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Are We reAdy for A NeW World

CurreNCy?In times of economic distress, investors seek what has been termed a ‘hard currency’ to protect their savings from risk. In the past, the US dollar, the Swiss franc, the Japanese yen, the British pound sterling and even the euro have all been per-ceived as safe-havens. However the 2008-2009 financial crisis has threatened several currencies previously thought to be ‘risk-free’, forcing investors to question whether any currency is truly safe from risk. Given present scenario, should we be asking ourselves if it’s time for the world to consider a new reserve currency?

What makes a currency dependable?

A hard currency is defined as a currency that has proven reli-

able in retaining its store of value. In other words, it must maintain or appreciate its exchange rate against other currencies. It should there-fore be freely convertible into other currencies and highly liquid in the foreign exchange market. The more stable the economic and political structure of a country is, the more reliable its currency becomes in re-taining its store of value. This takes time; a country must establish an entrenched method of government and an orderly system of political transition to ensure that political uncertainty does not impact confi-dence in the national currency. As for economic stability, hard curren-cies tend to originate from coun-tries that are highly industrialised. A currency is more likely to survive if its national economy remains robust during a downturn. But during exogenous shocks, when an economy is adversely hit by global recessions, a country has little con-trol over its national currency as it has little choice but to surrender to market forces.

Demand for a hard currency in-creases during periods of economic uncertainty. When economic crises cast doubt on the sustainability of one currency, this forces rapid speculative outflows from one cur-rency to another that is perceived to be safer. When political structures threaten to fall apart due to war and instability, it significantly reduces the ability of a currency to survive over the long term and retain its value. Thus investor confidence nose-dives and investors turn instead to more stable financial assets. The recent financial crisis has been a particularly turbulent time for currencies historically perceived as ‘safe-havens’. Perhaps this highlights a need to introduce a completely new currency that has no attachment to a particular na-tion’s economy. It could act as the reserve currency for the world, free from the influence of any particular economy’s performance.

How would this reserve currency work? The idea of a ‘world currency’ was suggested by Russian President Medvedev in 2009 at a G8 meet-

By Roshni Rajan

ing in London. Suggestions for an independent reserve currency have been echoed by the UN, central banks, China and reputed economic analysts. In the ab-sence of market forces regulating the value of the reserve currency through supply and demand, a global central institution could set capital requirements for central banks around the world to hold the reserve currency. Much like the global equivalent of the Federal Reserve, this institution would be responsible for pursuing a global monetary and fiscal policy to manipulate the value of the reserve currency and ensure that it retains its value. Central banks could then hold a stockpile of this new cur-rency instead of the dollar or the pound, and could lend and borrow it with other central banks as well as with the global reserve bank. It would function in the same way as a national currency, without being subject to different national econo-mies.

Advocates of this new reserve cur-rency have proposed using SDRs – the International Monetary Fund’s Special Drawing Rights. SDRs are allocated to countries by the IMF and are used as units of payment on IMF loans. Their value is derived from a weighted basket of four currencies: the Euro, the US Dollar, the British Pound and the Japanese Yen. Member quotas, exchange rates and weekly inter-est rates are managed by the IMF. This suggests that far from being a hypothetical question, the founda-tions for a new world currency are already in place – a fully function-ing independent currency may just be on the horizon.

There are alternatives – basing a new reserve system on several national currencies rather than one single currency, or a Bretton-Woods style system of managed

4MARKETS | THE ANALYST

international exchange rates. But is it the case that we do not need a new world currency, but are simply witnessing the transition period from the dominance of one reserve currency, the US Dollar, to the rise of another?

The Future of the Yuan

The rapid rise of China as a trad-ing superpower has brought the Yuan’s significance on the global stage into sharp focus. At the same time, China’s leadership grows ever wearier of the country’s $1.95 tril-lion dollar reserves, which makes it dangerously dependent on the loose US monetary and fiscal policies which struggle to preserve the dollar’s value. The country has proposed shifting away from the US Dollar as a reserve currency and officials seem prepared to give the Yuan an international role. Analysts have even suggested that the sheer size of the Chinese economy makes the adoption of the Yuan as the new world currency inevitable. Yet, is the Yuan ready to become the new reserve currency? Commentators and academics don’t seem to think so. The main obstacle to the ‘inter-nationalisation’ of the Yuan is the capital controls that the Commu-nist government have placed on the currency to prevent market forces from causing fluctuations in its value. As mentioned, a currency can only be deemed a ‘safe-haven’ if it is freely convertible into other currencies, allowing investors and financial institutions to sell and trade it without restrictions. The Chinese government would have to abolish these capital controls, significantly reform its laws and open up the securities market to foreign investors, allowing free investment in Yuan-denominated stocks, bonds and bank deposits as well as free capital repatriation. The Chinese capital markets would have

to be highly liquid and deep – a very large transaction is required to change the market price – which is far from its current status. So if China intends to succeed the US dollar as the reserve currency of the world, it has a long way to go. This is not a transformation that is going to happen within the next five or ten years.

However, it’s not just a matter of opening up the domestic market. For the Yuan to become a ‘hard currency’, the Chinese economic and political structure must gain investor confidence and long term trust. This is difficult to establish for a country with an authoritarian government – how can investors be sure that the Chinese government will resist its inherent need for con-trol when the Yuan suffers in the international currency market?

Commentators believe that the foundations for the Yuan to be-come the new reserve currency are already in place. For it to become a reality, there needs to be a long term transformation in the way the Chinese economy is managed. There are signs that the Chinese authorities are willing to slowly open up their economy, for exam-ple engaging in currency swaps with other central banks to allow trade with China without using the dollar as an intermediary currency. However, a more likely outcome of the rise in significance of the Yuan is that it is eventually incorporated into the basket of currencies that make up the SDRs currently circu-lated by the IMF. To have a broad perspective of the concept of safe-haven curren-cies and the reserve currency of the world is to conclude that the global economy is operating in a particularly uncertain time. As the long term stability of the dollar and other well-established currencies is cast into doubt, investors and

analysts have begun to contem-plate alternatives. While the Yuan seems unlikely at least in the short to medium term to become a hard currency and assume the US dol-lar’s position as the reserve curren-cy of the world, it is interesting to consider whether a new independ-ent currency could be established, using the IMF’s SDRs as a basis. It seems at least in the near future that the status quo will remain – the US dollar will preserve its domi-nance over the global economy in the aftermath of the crisis. Perhaps in the long term central banks will trade in SDRs instead.

5 ARE WE READY FOR A NEW WORLD CURRENCY?

AfriCA’s mobile teChNology revolutioN

“Mobile-phone technology is like fire: as soon as a society gets it, it can’t imagine life without it,” Rollo Romig, former assistant director of the NYU Journalism in Ghana program.

No technology has ever spread faster around the globe than

mobile phones and nowhere more so than in the continent of Africa.

At a time when revenues in mature markets are deteriorating, the rapid growth prospects of emerging econo-mies continue to grab the attention of telecoms groups that are aiming to prolong years of strong growth. Mo-bile banking has grown to a market of 40 million users in many parts of Africa; attesting to the fact that rapid adoption of mobile phone technology has caused a paradigm shift in phone use from one that simply allows for quicker and cheaper communica-tion to one that could transform lives through innovative applications and services. So what has driven this massive growth in the market? What are its potential economic opportunities?

And what challenges does the tel-ecommunication market in Africa face in the future?

From growth to boom: why it has happened

Just over a decade ago, only 10 per cent of the African population had mobile phone coverage, primarily in North and South Africa. By 2008, 60

percent of the population (477 million people) and an area equivalent to the United States and Argentina combined had mobile phone service. By 2012, most villages in Africa will have coverage, with only a handful of countries – Guinea Bissau, Ethio-pia, Mali and Somalia – relatively unconnected.

This rise in mobile phone sub-scriptions is surprising given the prevalence of poverty in sub-Saharan Africa and the relative price of mobile phone handsets and services. Approximately 300 million Africans are classified as poor (living on less than US$1 per day), with 120 million liv-ing on less than US$0.50 per day. The price of the cheapest mobile phonein Kenya, for example, costs half the average monthly income, whereas the price of cheapest mo-bile phone in Niger is equivalent to about 12.5 kilograms of millet, enough to feed a household of five for five days.

A large part of this boost comes from the innovative use of mo-bile phone technology by local entrepreneurs. For example, community mobile payphone, an innovation unique to the devel-oping world has helped bring mobile phone usage to the poor-est areas of Africa. These mobile phones are owned and operated by entrepreneurs who buy airtime

By Sakina Kabir Badamasuiy

6MARKETS | THE ANALYST

from the network and subsequently sell it to local people who don’t own phones themselves. There is now an increased awareness in rural areas to the benefits of using a mobile phone and this has led to more phone purchases in the community. A recent survey reported that 97% of Tanzanians now have access to a mobile phone as a result of the com-munity payphone model.

The cheap prices of some phone services in Nigeria have also re-cently boosted demand. Bharti has cut call prices of its mobile services by 50%or more in 11 countries to attract more customers. It aims to target the low-end, rural customer segment in the region.

Indeed, in contrast to their use in the developed world, mobile phones in Africa are used for a wide vari-ety of tasks, from sending money to family members to buying a fish from the market. For example, contract labourers can now provide their phone numbers to potential employers and move on to another site, instead of waiting hours at a workplace for potential job offers.

Africans have accelerated the growth of their local telecommu-nications markets by skipping less efficient technologies previously employed and moving directly to relatively more advance ones and employing them in vast sectors in the economy. As such, the telecom-munications industry continues to attract a flurry of public and private investment.

The changing landscape of invest-ment

The four biggest mobile phone markets in Africa are Nigeria, South Africa, Kenya, and Ghana. Strategic investors in Africa’s mobile industry include South Africa’s MTN, India’s Bharti Airtel, France Telecom (via its Orange brand), Britain’s Voda-

fone and Luxembourg’s Millicom.

Market liberalization has generated large-scale investment in telecom-munications networks, mainly from the private sector. Most countries have adopted a liberal policy toward foreign investment in telecommuni-cations, allowing foreigners to own at least 51% of telecommunications companies with some even allowing foreign investors to have complete ownership of subsidiaries. Only four countries (the Comoros, Djibouti, Eritrea, and Ethiopia) still retain major restrictions on foreign invest-ment in operators.

According to research by Mobile Monday, the MTN Group which holds a 50 per cent market share in Nigeria has plans to invest $1 bil-lion in improving its mobile phone network in Nigeria. This will in-clude building a fibre optic network, improving transmission capacity, building more base stations and im-proving the capacity of its network.

Bharti Airtel, India’s largest and the world’s fifth largest telecommunica-tions company has, with its pur-chase of Kuwait-based Zain entered the market of 15 African nations. It has also partnered with IBM and

Source: Africa Development Bank

has announced that as part of a 10 year deal, they will provide IT services for 16 African countries. IBM will install and manage the IT

infrastructure and applications to support Airtel’s goal of providing affordable and innovative mobile services throughout Africa.

Mobile Banking- the next big thing?

Aside from regional expansion, the mobile phone industry is also experiencing considerable growth in innovation and new technolo-gies. One of such areas is in mobile banking and commerce services.

Mobile banking involves the use of a mobile phone or device to under-take financial transactions linked to a client’s account. Banks are recognizing the potential of reach-ing millions of prospective custom-ers, especially the rural population who account for more than 60% of Africa’s total population and have no access to banking services. In Nigeria, for example only 20 out of its population of 150 million have access to banks. The African rural commercial bank branch networkis still underdeveloped. However, since more than 50% of the adult population in Africa has access to mobile telephone, mobile banking couldtake services to remote areas where conventional banks have been physically absent.

A good example of a successful mobile banking scheme is M-Pesa, a mobile-phone based money transfer service for Safaricom (a Vodafone affiliate) allows mobile

7 AFRICA’S MOBILE TECHNOLOGY REVOLUTION

phone subscribers to send as little as 50 Kenyan Shillings in second and is now being replicated across the globe with transactions worth $6,392 billion going through M-Pesa since its inception in Kenya. Commercial banks, anticipating an increased use of M-Pesa by Ken-yans, are now racing to partner with mobile phone firms to remain pertinent.

Subscribers to mobile banking net-works will be now open accounts, check their balances, pay their bills, transfer money, and cater for their daily basic needs. There is also mounting evidence of positive social impact on poorer people and communities as a result.

In order to support this, govern-ments would need to pioneer new legislation and regulations for mobile money and also urge the international community to actively support the expansion of solid regulatory frameworks and relevant institutions.

The future: a bumpy road or smooth sailing?

Recent trends which have seen smart phone prices cut globally have driven analysts to predict that more smart phones will be lowered to mass market price points in Afri-ca over the next few years. Android phones continue to increase their market penetration with Huawei’s $100 Ideos becoming a 2011 best-seller in Kenya. According to the African technology research publi-cation, Balancing Act Africa, there will be more Blackberry, iPhone, Android and Windows Phone 7 OS presence in the next few years ,representing a major shift from the current dominance by Nokia’s Symbian OS.

However, there are serious doubts being raised about the sustainability of growth in market for telecoms

infrastructure. Emerging Capital Partners, the Africa-focused private equity group thinks the African telecoms market is at an “inflection point” with the large, established operators looking for new ways to drive growth without investing vast sums on infrastructure. The group, among others has decided to con-centrate on smaller infrastructural investments where it thinks have more values to be found.

Fraud is also particular problem in many African markets, partly because so many subscribers are prepaid, so no bills are issued that can act as flags for the occurrence of fraudulent transactions, whether caused externally or internally -- and the latter can be quite com-mon. Operators are therefore interested in adopting more sophis-ticated control techniques, such as those that can handle cost-effec-tively large volumes of low-value transactions, and this is leading to the adoption of a new approach to revenue assurance.

Pyramid Research points out that governments will need to ensure regulatory flexibility -- not some-thing normally associated with much of the region -- because the mobile service providers will need active central-bank support and flexibility.

But is investing in Africa less risky than investing in developed equity markets amid current volatility? According to the chief strategist at Insparo Asset Management, an Africa and Middle East specialist, the answer is “yes” because there is more upside potential. Risk is better priced in Africa than in developed markets and underlying fundamen-tals are stronger.

We do, however need to exercise caution when considering the vi-ability of the telecoms industry as a whole. Given its meteoric growth

and the fact that communications today are no longer a luxury but a necessity, it is important for op-erators to understand that without the adequate regulatory systems and infrastructure necessary, the only certainty in the future of the telecoms industry might be uncer-tainty.

8MARKETS | THE ANALYST

soCiAl NetWorkiNg CompANies ANd the

rACe to go publiCBy Andrew Jackson & Jankee Gohil

Social networking websites such as Renren, LinkedIn and Facebook have

recently attracted a remarkable amount of attention on the Initial Public Offer-ings (IPO) scene. Whilst some of these companies have already engaged in IPO activity, countless rumours about potential equity offerings are being generated around those companies which are still private. Can money be made? Is it all a bubble? Who will be next? These are the questions investors seek answers to, and although answering them is beyond our capacity, this article will give an account of what has hap-pened so far within the sphere of internet-based companies going public. We look at Facebook, which has received extensive attention from the financial community regarding its prospects of going public, and we seek to understand why it has not yet offered equity in its successful business. We then describe the experiences of two com-panies which have already floated, Renren and LinkedIn, and ultimately, we will give our opinion on whether this is a case of all hype and no substance; in other words – are investors getting seduced by what can very possibly be a bubble akin to that of the dot-com boom and bust? To begin, how-ever, we will explain why companies choose to go public in the first place.

Why go public?

Rather paradoxically, there are several disadvantages which unfortunately ac-company the course of going public. The process of floating a company, for instance, is extremely expensive. Legal, accounting, underwriting and other fees often amount to colossal sums, and there is the inevitable risk that if the procedure fails, a significant proportion of the capital invested in the hope of a successful equity release will be lost. Senior managers also find that as leaders of public companies they will have to deal with pressure from shareholders and regulators. A public company is legally obliged to publish all information about its operations, including executive compensa-tion and past violations of regulations – most companies would undoubtedly prefer to keep such information private. Finally,

companies that go public lose a certain degree of flexibility with regards to decision making. Indeed, large scale strategic deci-sions and other arrangements with respect to the direction of a public company will no longer be subject solely to executive managers’ opinions.

So in light of all of the above, it may seem surprising that internet-based companies wish to float in the first place. However, there are certainly also advantages of going public. The main reason companies such as Renren and LinkedIn have already opted to issue equity is the need to raise capital; with a loss of managerial control comes a con-siderable inflow of cash, that is, the capital investors have injected to purchase the newly offered stock. Moreover, going public also gives management future access to capital markets if the need to access further funding occurs. Finally, going public is a very good way for organizations to promote themselves – publicly traded companies are generally better known than private companies – and they generally portray an image of stability and transparency.

Facebook: the story so far.

Now that it is clear that there are not only advantages but also disadvantages which come with the undertaking an IPO, it is not surprising that some web-based companies have delayed floating their operations on the stock market. Amongst those com-panies which are still in line to produce an IPO, Facebook, which benefits from over 750 million users, has certainly taken the lion’s share of the attention. Investors have been trying to estimate when the first shares in Facebook will be up for grabs, but the behemoth of social networking is in no rush to offer them a stake in the company. The long awaited Facebook IPO has been recurrently delayed, and there are several reasons for this.

As mentioned above, the move to go public comes with both advantages and disadvan-tages, and it seems that in the case of Face-book, floating on an exchange comes with only limited benefits and rather. As men-tioned above, the move to go public comes with both advantages and disadvantages, and it seems that in the case of Facebook, floating on an exchange comes with only

limited benefits and rather consequential drawbacks.

_____________________It seems that in the case of Facebook, floating on an ex-change comes with only lim-ited benefits and rather conse-quential drawbacks.

Indeed, factors such as the significant IPO-related costs Facebook would have to stomach, the need to respond to share-holder pressure and public scrutiny are aspects of going public which Mark Zuck-erberg, Facebook’s CEO, wants to avoid for as long as possible. Moreover, the luxury of having full flexibility with regards to the direction in which to take his com-pany is a luxury Zuckerberg is reluctant to give up. Having to disclose all financial information, strategic decisions as well as operational errors, is a burden that is particularly heavy for a company like Fa-cebook, which prides itself on flaunting its success whilst keeping all inside informa-tion secret from the public. With regards to the benefits of launching an IPO, they are simply not that attractive to Facebook’s top management.

Indeed, Facebook is not under pressure to raise capital, as it is already extremely successful at generating cash. Its revenue is estimated to reach almost $4.3 billion by the end of 2011, which is over twice the amount it generated in 2010. In 2012, the estimate is that revenue should reach al-most $5.8 billion in advertisement revenue alone. Finally, it appears as if Facebook is delaying an IPO simply because the time isn’t right. For an IPO to be successful, it is preferable to be operating in a stable market. The current market conditions are simply too volatile, which is putting some companies off offering equity in their business.

Facebook is a rather unusual case because on the surface it seems that there is no rational reason for it to go public, yet although a specific date is unknown, it is widely assumed that sooner or later inves-tors will be able to trade shares in Face-book. Why so? The answer lies in the fact that Facebook has actually been cornered into being legally obliged to report its financials to the public. Indeed, the Securi-ties and Exchange Commission (SEC), the regulating body of financial services in the US, requires any company which accrues more than 500 investors to publish all of

9 SOCIAL NETWORKING COMPANIES AND THE RACE TO GO PUBLIC

its financial details in the first quarter of the following year. In January 2011 Facebook went beyond the 500 shareholders threshold when Goldman Sachs became an inves-tor and therefore, it will have to publish its financials by the end of the first quarter in 2012. This does not mean that Facebook has to go public, but it may make sense to do so. Given that it is obliged to report its figures and bear the burden of public scrutiny, then it might as well take advantage of the situa-tion and take the full leap by floating on an exchange.

Renren & LinkedIn: Paving the way.

But if certain web-based companies such as Facebook and Twitter have delayed going public for a while, other firms have already taken the plunge. In particular, China’s answer to Facebook, Renren Inc, listed on NYSE on 4th May 2011 at a price of $14, raising $743.4m for the company. The stock rose to $21.93 during the first day of trading before closing at $18.01, which is 28.6% above the initial price. However, since the IPO, as shown by the chart below,

Renren Inc. the share price has continued to fall and the firm has lost more than half its value. On the other hand, on 19th May 2011, LinkedIn listed on NYSE and released shares to the public at a price of $45. The stock reached as high as 171% above the IPO price during the first day of trading and closed at $94.25, almost 110% above the initial price. The IPO valued the company at $3bn, but by the end of the first day of trading, the company’s value soared to $9bn. Looking at the chart below, LinkedIn’s stock price fell drastically

LinkedIn.

after its floatation but as of yet, it has not fallen to anywhere close to its IPO price.

Why is it that the two companies have performed so differently post-IPO? Renren’s valuation stood at $7.5bn after the first day of trading, which is almost 100 times the 2010 net revenue of $76.5m, excluding ad-vertising rebates that are often paid in China. It has been a general trend over the last few months that Chinese technology compa-nies listed in the US have taken a hit amidst concerns over the veracity of financial state-ments, fraud allegations and issues relating to censorship. For example, the Chinese technology firm Longtop was delisted from NYSE in August 2011 after the SEC charged the company for filing inaccurate financial information and suspended its trading. The Chief Financial Officer of Longtop, Derek Palaschuk, happened to also be the chairman of Renren’s audit committee. He resigned prior to the IPO with the aim of protect-ing the company’s reputation. Secondly, pre-IPO, there was some uncertainty about the number of users that the company has. While they initially declared that in the first quarter of 2011, the number of users grew by 7 million or 29%, an amended filing on 27th April 2011 stated that the number of users grew by 5 million or 19% instead. This raised concerns over the accuracy of the informa-tion in the firm’s IPO prospectus, which might mislead potential investors.

In the case of LinkedIn, the stock price has not suffered in a similar fashion. Yvan-Claude Pierre, a partner at the law firm DLA Piper, argued that LinkedIn’s stock perfor-mance post-IPO is an indication of the level of demand for successful internet companies. According to Reuters, LinkedIn’s IPO price valued the company at 17.5% above its 2010 revenue and after the first day of trading, the company was worth 37 times its 2010 revenue. Was the IPO valuation an under-valuation or are investors overconfident? It is interesting to note that LinkedIn is expect-ing to make a loss in its first year as a public company. Why then is the share price so high and are we on the brink of a bubble?

A news release by PwC in May 2011 states that during the peak of the technology bubble in 2000, some listed UK technology companies were trading at 90 times their PE ratio, in comparison to 25 times the PE ratio for the market as a whole. Today, the multiple is closer to 15 times PE ratio for the market as a whole and this is similar for the US. Therefore, on the face of it, there does not appear to be a bubble. However, the way in which social media companies are valued is slightly different in that the firms often prioritise growth over earnings since the

benefits of social media sites increase as the user base expands. Therefore, perhaps ‘value per user’ may be a more valid way to measure the value of a firm. This enables social media companies to be comparable to established telecom operators and broadcasters. Accord-ing to Ian Coleman, a partner at PwC, “When you look at value per user metrics, the valuations for some of these businesses begin to make more sense. The LinkedIn share price increased sharply on IPO, taking its enterprise value to $9bn. This represents value per active user of around $120, which compares to Skype’s value per active user of $50 (based on the Microsoft transaction), implying that investors believe it may be easier for LinkedIn to monetise its customers. Certainly, the Skype benchmark is based on a hard cash deal and therefore provides some support for other social media valua-tions recently inferred”. Simon Har-ris, technology valuation specialist at PwC, commented that “there does not appear to be a bubble forming for the technology sector as a whole, and there also appears to be some support for the valuations of social media sites. Google was trading on very high multiples after its IPO and is now a hugely successful company, so high PE multiples should not necessarily be taken as an indica-tor of a business being overvalued...The ability of social media sites to innovate in the long term, and to retain and monetise their subscribers, will be the true test of whether such valuations are merited”, and consequently, answer the key question of whether we are facing a bubble.

10MARKETS | THE ANALYST

ChiNA’s CurreNCy

CoNuNdrumIntroduction

China has taken the world by storm in recent years with its expedient rate of

economic growth and cemented itself as the world’s second-largest economy. Such growth is due in part to China’s strong manufacturing industry and thus a signifi-cant amount of this growth is export led. China’s influence in the world economy was minimal until the late 1980s. Only after cer-tain economic reforms initiated after 1978, was China able to invest significantly in in-dustry, services and participate more freely in international trade to boost growth. However, as a consequence of such export-led growth, China will face inevitable pres-sures on certain macroeconomic variables, a significant one being on its exchange rate. China has adapted a currency policy that lets it actively intervene in the currency market to affect rates, thus indirectly affect-ing the relative purchasing price of imports and exports. It is no surprise then, such a policy has drawn criticism from prominent world leaders such as Barack Obama who feel their own nation’s growth prospects maybe compromised as a result of this policy stance. Nevertheless, China can use its currency policy as powerful tool by not only bettering its own economic prospects but also in the process significantly affect other world economies’.

Political-Economic Factors

China’s exchange-rate policy must be understood within the context of two political-economic factors: first, China’s overall development strategy which aims to build up the nation’s economic and political power with market mechanisms and sec-ond, China’s geopolitical position. The Chi-nese development strategy, which emerged gradually after Deng Xiaoping began the process of “reform and opening” in 1978, is based on a careful study of how other industrial nations got rich—and in particu-lar, the catch-up growth strategies of its east Asian neighbours Japan, South Korea and Taiwan after World War II. A key lesson of that study is that every rich nation, in the early stages of its development, used

export-friendly policies to promote domes-tic industry and to accelerate technology acquisition. Other important political fac-tors such as a desire to maintain domestic and regional macro-economic stability play a role in keeping inflationary pressures at bay and force a gradual upgrading of the industrial structure. From the point of view of Chinese policy makers, all of these objec-tives sug-gest that the exchange rate should be carefully managed, rather than left to unpre-dictable market forces.

Dual-Exchange Rate System

Prior to 1994, China maintained a dual exchange rate system. This consisted of an official fixed system used by the goverment, and a relatively marketbased exchange rate system that was used by importers and exporters. However, access to foreign exchange was highly restricted in order to limit imports, resulting in a large black market for foreign exchange. The two rates differed significantly. The official exchange rate with the dollar in 1993 was 5.77 Yuan versus 8.70 Yuan in the market-based system.

Unification

In 1994, the Chinese government unified the two exchange rate systems at an initial rate of 8.70 Yuan to the Dollar, which eventually was allowed to rise to 8.28 by 1997 and was then kept relatively constant until July 2005. From 1994 until July 2005, China maintained a policy of pegging the Chinese Yuan (CNY) to the U.S. dollar at an exchange rate of roughly 8.28 Yuan to the Dollar. The peg appears to have been largely intended to promote a relatively stable environment for foreign trade and investment in China (since such a policy prevents large swings in exchange rates). This peg was largely maintained in part by China buying (or selling) as many dollar denominated assets in exchange for newly printed Yuan as needed to eliminate excess demand (or supply) for the Yuan.

More Modification

The Chinese government modified its

By Atin Dhawan & Dawn Soh

currency policy on July 21, 2005. It an-nounced that the CNY’s exchange rate would become adjustable, based on mar-ket supply and demand with reference to exchange rate movements of currencies in a basket, and that the exchange rate of the U.S. dollar against the CNY would be ad-justed from 8.28 to 8.11 Yuan, an apprecia-tion of 2.1%. From July 2005 to July 2008, China’s central bank allowed the CNY to appreciate against the dollar by about 21%. However, once the effects of the global economic crisis became apparent, China halted appreciation of the CNY in an effort to help Chinese industries dependent on trade.

China’s Reasons

Export-Led Growth

China’s central argument for adopting such policy is that it believes the CNY is significantly undervalued against the dol-lar. Another significant effect of under-valuation is that it makes exports cheaper in foreign countries.

Further to this, eliminating exchange rate risk through a managed peg also increases the attractiveness of China as a destination for foreign investment in export-oriented production facilities. China maintains that countries that have raised themselves from poverty to wealth have done so through export-led growth. Thus, the management of the exchange rate by Chinese leaders to favour exports is part of a long-term goal to meet development objectives such asthe creation of infrastructure and basic

_______________________The management of the ex-change rate by Chinese leaders to favour exports is part of a long-term goal to meet devel-opment objectives

11 CHINA’S CURRENCY CONUNDRUM

MARKETS| THE ANALYST

industries.

The drawback to this perhaps is that while such a policy favours high levels of export led growth; it makes foreign products more expensive for China at home. Such a policy then, also has an element of protec-tionism. This particular aspect has been picked up in particular by the US, who are pinning hopes of recovery on a doubling of exports, which the current currency policy of China will impede.

China’s stance on this is also corroborated by the strong track record its policies have produced: consistent GDP growth of around 10% a year since the late 1990s, inflation consistently at or below 5%, export growth of more than 20% a year, and a steady increase in the sophistication of Chinese exports. Until some kind of crisis convinces them that their economic policies require major adjustment, China’s economic planners are likely to stick with their current formula. And this includes currency policy.

Wider Impact

Rebalancing the global economy

The result of China’s currency policy has resulted in massive global imbalances on the world economy. China’s huge trade surplus, combined with the US’ huge trade deficit, is strong evidence of a worldwide global imbalance. There is a need to re-duce these global imbalances. One school of thought argues that global imbalances are the main cause of the recent global financial crisis. Being unsustainable in the long run, as analysts have proposed, their unwinding would definitely pose a major risk to the world economy, unless China moves in swiftly to act on the problem.

Domestic effect

The undervalued Chinese Yuan raises the price of US imports relative to Chinese exports. US firms lose their competitive advantage against Chinese businesses and as a result, reduce their production and employment due to a significantly undervalued Yuan. The size of the trade deficit plays an important role in dem-onstrating the impact of the trade deficit on the US manufacturing sector and its employment rate. It had been reported that the US lost almost 500,000 manufac-turing jobs since March 1998, an outcome of the rising trade deficit. A consequence of the trade deficit is also an increase in income inequality of 20-25%, according to economists.

External effect: Why US needs China and China needs the US

Undervaluation also lowers the export competitiveness of the US goods, and results in the worsening of the balance of trade. The US trade deficit, which makes up a large portion of the US Federal deficit, is an indication of the US’s reliance on China. China, which has more than $2.4 trillion in foreign exchange reserves, is single-handedly the largest foreign holder of American debt. As a result of its exchange rate policy, China has a huge amount of its US dollar reserves which it uses to invest in US Treasury securities and other dollar denominated assets.

With the US Federal debt surpassing the maximum legal debt ceiling of $14.29 trillion in May 2011, US Congress leaders had to lift the government’s debt ceiling to avoid a default. Having its debt-to-GDP-ratio pass the 100% mark, the US largely depends on China to help alleviate its debt situation. This reliance is evident, as China is the largest investor in US Treasury securities, holding $1.137 trillion (as of Aug 2011), or almost 26% of all foreign-held Treasury securities.

As a result of its large investment in the US’s Treasury securities and other dollar denominated assets, in return, China is pressurized to ensure that its investment does not go into default. However, after the US saw a downgrade of its credit rat-ing by one notch, from AAA to AA+, for the first time in 70 years China released a statement that it had “every right now to demand the United States address its structural debt problems and ensure the safety of China’s dollar assets”.

Prediction for the future: China’s currency stance

To appreciate the Yuan or not?

From current observations, China is still not willing and prepared to allow the Yuan to appreciate at a faster rate, owing to various economic and political reasons. At the very least, analysts do not expect China to make any adjustments to its currency peg to the US any time soon. Hence, China has few other options but to continue buying US treasury securities to store swelling reserves, given that the US market is preferred due to its size and relative risk as compared to others.

However, a stronger Yuan would be beneficial in reducing imbalances within

the global economy. By making Chinese imports cheaper, controlling inflation within China, and reducing the US trade deficit, this is a win-win situation for both China and the US. With one of the fastest growing economies in the world, China requires a high demand for energy to fuel and sustain its economy. Given its relatively small oil reserves, and being the second largest oil consumer in the world, China is reliant on imports for its oil supply. A stronger Yuan would mean cheaper oil imports. Chinese’s high inflation rate would also be tamed by an appreciation of the Yuan. In addition for the US, reducing its trade deficit, it can divert its attention from financing its debt to focusing on current economic goals such as education and healthcare, allowing for investments for the future. This realloca-tion of resources to finance the debt incurs an opportunity cost in terms of economic growth.

China as the new international re-serve currency?

China has indicated its interest to become an international reserve currency in the near future, after arguing that the US dollar is too unstable and risky for financial markets. However, in order to become one, China will have to loosen its tight grip on its currency. Given the huge political, economic and technical barriers involved, it is unlikely for the Yuan to become an international reserve currency any time soon. Nonetheless, in the short-run, we expect to see a gradual loos-ening of China’s currency stance. A stronger Yuan would benefit China’s economy and the world’s by helping shift growth from in-vestment and exports towards consumption and boost consumers’ purchasing power.

12

Civets: the Next

plACes to be

http://www.alphabric.com/civet

Ever since the term was institutional-ised by Goldman Sachs in 2001, the

BRIC countries (Brazil, Russia, Indonesia, China) have been the investor darling for over a decade. The financial community is rife with speculation and commentary on the success of these nations. However, due to the lauded status of these emerg-ing markets, many BRIC assets are well priced and thus any early mover advantage in investing in them has disappeared. Gaining a windfall from BRIC is increas-ingly unlikely, prompting investors with an appetite for big risk and reward to look for more exotic locations to invest, with many of them turning to CIVETS as the new frontier.

Looking at CIVETS

‘CIVETS’ (Colombia, Indonesia, Vietnam, Egypt, Turkey and South Africa) was first coined in 2009 by Robert Ward, Global Forecasting Director for the Economist Intelligence Unit (EIU). At first glance, the constituents appear to have little in com-mon. Geographically far-flung, they have vastly different political, cultural and reli-gious institutions. GDP per capita ranges widely, from $1,200 in Vietnam to $10,000 in Turkey. What they do have as a unify-ing feature, are their youthful populations

with an average age of 27. This proffers a large and cheap workforce to producers and a growing market for manufactured products. Comparatively, BRIC productiv-ity growth and capabilities are expected to wane, due to their ageing populations. Fur-thermore, CIVETS have relative political stability, sophisticated financial systems, and most importantly, diversified econo-mies - which offers stability to economies. CIVETS are for the most part, unaffected by issues plaguing advanced countries: inflation, trade imbalances and high public debt. Despite being grouped together, the potential of the CIVETS bloc varies greatly, and investors should take a closer look at each economy before proverbially plunging in.

The Leaders

With a population of 240 million, Indone-sia is the fourth most populous country in the world. Its massive domestic consump-tion market, which accounts for two-thirds of its GDP, helped the country weather the 2008 financial crisis without significant reliance on government funding. Accord-ing to a report by Deutsche Bank, middle-income consumers are expected to double from 25 million in 2010 to 52 million in 2015, which could further buoy consumer spending. Being relatively sheltered from global trade flows, Indonesia has man-

aged to perform well despite the mounting financial gloom in the global economy, growing by 4.5% in 2009 and 6.1% in 2010.. Strong domestic demand, low unit labour costs and a strategic location between China and India also make it an attractive location for manufacturing. Meanwhile, the government is boosting capital spending to ease infrastructure bot-tlenecks that have long impeded growth. The biggest thing standing in the archi-pelago’s path to unprecedented economic growth is endemic corruption. However, the Corruption Perception Index pub-lished by Transparent International argues that the situation is improving steadily.

Next on the list is Turkey, whose economy grew by 8.9% in 2010 and over 10% in the first half of 2011, one of the fastest in the world. Unlike other CIVETS nations, Tur-key has scarce natural resources. Instead, its economy is primarily composed of the service and industrial sectors. Its banking sector is booming due to a growing de-mand for corporate and consumer finan-cial services in the country and the sur-rounding regions. Proximity and close ties to Europe has proved very advantageous for Turkey, as the continent comprises half of Turkey’s export market. Turkey is in the process of obtaining a free trade agree-ment with the EU, which would allow the sale of tariff free manufactures in the EU market. On the other hand, the govern-ment is also working to increase exports to Middle East trading partners to hedge against the economic volatility in Europe. Overall, the outlook for Turkey remains optimistic, although a high inflation rate and an expanding current-account deficit are indications of an overheating economy.

Colombia, a country once mired in the depths of terrorism, drug trafficking and organised crime, is now catching up to its full potential. With security in the country improving dramatically in the past decade, levels of foreign direct investment have increased from $2.1 billion in 2002 to $6.8 billion in 2010. This number is expected to increase in the coming years, as the United States Congress recently ratified the US-Colombia free trade agreement (FTA). The mining industry has received significant funding injections, due to the substantial coal and petroleum reserves in the country. Another factor that has contributed to heightened investor interest is a healthy business climate, fostered by the former government’s investment in infrastructure and job creation. Accord-ing to Frank Holmes, CEO of U.S. Global Investors, investing in the Columbia is extremely easy and the country is glob-

By Shu Hang Low

13 CIVETS: THE NEXT PLACES TO BE

MARKETS | THE ANALYST

ally competitive in terms of business sophistication, market size, and strength of investor protection. The biggest issue with Colombia is an over-reliance on the commodity market, which may render its economy highly volatile.

The Hopefuls

Vietnamese growth has paralleled that of China: driven by dirt cheap labor costs. The appreciation of the renminbi and the Chinese policy to increase salaries have prompted multinationals to build factories in the South-East Asian country instead. Despite being characterised as an export-based economy (exports make up 70.7% of the GDP) and thus exposed to volatil-ity, Vietnam achieved an impressive rate of growth of 6.8% in 2010. Vietnam and China share similar traits. Like China, Vietnam has made a shift from a highly centralized, planned economy to a social-ist-oriented market economy since the mid-1980s. Being a communist state, the country boasts relative political stability and the centralised command and control that China also possesses. Unfortunately, investing in Vietnam remains a laborious process and the stock market is small and speculative. This is not surprising consid-ering that Vietnam was only inducted into the World Trade Organization in 2007.

South Africa is known for being a veritable treasure trove of natural resources. It is the world’s largest producer of platinum,

second largest producer of gold, and the third largest global coal exporter. While commodities are central for fuelling the economic growth of the country, the agricultural, services and manufacturing sectors are also being actively developed. However, the biggest selling point of the country is its role as the key trade and transit hub in Africa. With African coun-tries dominating the list of 2011’s fastest growing economies, South Africa offers a distinct comparative advantage - a gateway to the largely untapped African market. However, income equality in the country is extremely severe. With the second highest Gini coefficient of inequality in the world and half the population living below the poverty line, society is highly unstable. A high HIV rate is also crippling its work force, with 12% of South Africans living with HIV/AIDS, according to the 2007 UNAIDS report.

The Uncertain

Political unrest has caused Egypt’s future to look rather gloomy. However, the most pressing issue is a high inflation rate and high levels of public debt, which ac-counted for an alarming 80% of its GDP in 2010. Consequently, ratings services have downgraded Egypt’s debt rating, increas-ing borrowing costs for government. The once dynamic stock market has lost nearly half its value and the government may be forced to seek a $3 billion loan from the International Monetary Fund. Egypt may

be able to revive its stagnant economy when the political arena is stable. Relative to its CIVETS peers, Egypt is a struggling player in the coalition.

Conclusion

CIVETS will play an integral role in facilitating the economic power shift from the West to the East, especially since the advent of economic crisis in the United States and Europe. Still lagging behind ad-vanced economies; CIVETS should be able to maintain their current levels of rapid growth by technology transfer, replication of production methods and institutions. As any entrepreneur that invested in BRIC in the early 80s will tell you, a central tenet of investing is doing it before everyone else. Right now, CIVETS may just be the ‘pre-Ipod’ Apple Inc. of the decade. “In today’s world, you can’t afford to wait for business. You have to go where the business is,” said Michael Geoghegan, former chief execu-tive of HSBC.

14

the CAse of boA: too big to

suCCeed?By Benjamin J. Olson

15 THE CASE Of BoA: TOO BIG TO SUCCEED?

How a Bank’s Greatest Asset Became Its Greatest Liability

Given the on-going deluge of negative press, it’s hard to

recall that not too long ago Bank of America was regarded as the firm that was built to last. In 2006, the behemoth financial services conglomerate officially surpassed Citigroup in market-capitalization, becoming the largest bank in the world and marking the crowning achievement of former CEO Ken-neth Lewis’ historic tenure. Lewis, the polarizing empire builder who did not shy away from making his intentions known, subscribed to the age-old adage that bigger is always better. Initially, Lewis’ strat-egy of exponential expansion via the constant acquisition of largely battered assets seemed ingenious. When the financial crisis hit in 2008, many analysts believed that Bank of America was best able to weather the storm given its robust, diverse portfolio of holdings. With divisions spanning global retail banking, wealth management, consumer real estate, card services, and beyond; the diverse revenue stream allowed Bank of America to remain afloat whereas one-trick competitors like Lehman Broth-ers, Bear Stearns, and Washington Mutual fell by the wayside. Yet in a twist of cruel irony, the strategy that once seemed to be the Char-lotte, North Carolina-based bank’s saving grace now appears to be its downfall.

Fresh off Bank of America’s 2006 expansion into the lucrative card services industry with the $35 bil-lion acquisition of MBNA (one of the world’s largest credit card issu-

ers); the crisis that ensued in 2008 seemed to be off-handedly playing into Lewis’ cards. When it became apparent that Bank of America would survive the crisis given its large expanse of operations and inclusion in the TARP program, Lewis saw a golden opportunity to enter into new markets. By snatch-ing up debilitated firms that had become victims of the crisis, Lewis sought to continue the expansion-ary policy that had come to define the bank. Yet this time the contro-versial CEO’s bet violently back-fired as the two major acquisitions that ensued during the midst of the 2008 crisis seem to be competing for the dubious distinction of be-ing amongst the worst deals in the history of corporate America.

When Bank of America purchased Countrywide Financial in January 2008, the bank’s stock was trad-ing around $36/share. With plenty of capital to lend, Countrywide’s $4 billion price tag seemed like a bargain for Bank of America to gain access to the then enticing mortgage market. Unfortunately, Lewis’ imperial mindset blinded him from the fact that Country-wide carried massive liabilities as the mortgage industry as a whole would go belly-up in the forthcom-ing months. Nevertheless, yet to feel the burden of the Countrywide deal and with a stock price that now hovered around $38/share, Lewis’ growth strategy persevered in September 2008 as Bank of America negotiated the acquisition of ailing investment bank Merrill Lynch for $50 billion. Much like in

the case of Countrywide, what Lewis saw in Merrill Lynch was yet an-other firesale deal that would further expand Bank of America into high revenue markets. Although expan-sion into the investment banking industry – in which Merrill Lynch once carried immense weight – seemed to be a prime opportunity given the vast financial deregulation of the period, Lewis once again let his obsession with growth deter him from the reality that Merrill Lynch also carried a great deal of liabilities as well as a Wall Street culture that would ultimately clash with a firm as diversified as Bank of America.

Three years have gone by since the financial crisis of 2008 and it has become wholly apparent that the ac-quisitions of Countrywide Financial and Merrill Lynch were “poison bait” for Bank of America. Initially it was the brutal losses garnered by Merrill Lynch that brought the most atten-tion. Stemming from Merrill Lynch’s revelation of suffering an initial $15 billion loss following its acquisition, Bank of America was held liable for lawsuits from not only shareholders but the federal government, which had already given Merrill Lynch $138 billion in financial support. On top of mere financial losses, Bank of America suffered a blow to its reputation as accusations of terse due diligence and the embarrass-ing exits of Merrill Lynch executives tarnished the bank’s good name. Nowadays Countrywide has taken over center-stage in the headlines as it has ascended to the primary role of hemorrhaging Bank of America’s balance sheet. On top of operating at a huge loss (nearly $9 billion in 2010), Countrywide has already cost Bank of America billions of dollars

__________________________It has become wholly apparent that the acquisitions of Coun-trywide Financial and Merrill Lynch were “poison bait”.

16MARKETS | THE ANALYST

in settlement payments with more likely to follow. To date, Bank of America has been on the hook for $600 million to pension investors, $108 million to the Federal Trade Commission, $45 million to the Se-curity and Exchange Commission, $13 billion in mortgage-security repurchases, and $8.5 billion to pri-vate investors; all for Countrywide Financial’s prior misgivings. Fur-thermore, such alarming figures fail to account for smaller lawsuits and those still pending like a $20 billion settlement sought by a collection of state attorney generals.

Currently Bank of America’s stock is trading at an all-time low as shares are now worth less than 1/5 of their value during the peak of 2008. So what happened to Bank of America? Was it simply a case of a few bad bets or was their torrid expansion strategy destined to fail? In my opinion, Bank of America became disillusioned in the “arms race” that followed the repeal of the Glass-Steagall Act and the phenom-enon of wholesale funding, naively vowing to become the biggest bank in the world without regard for what made the bank successful in the first place. Such an argument is best illustrated by Bank of Ameri-ca’s back-and-forth deliberations as to whether they should charge cus-tomers $5 per month to use their debit cards for purchases. The pro-posed policy stems from a desper-ate need for revenue to counteract

the heavy losses from Merrill Lynch and Countrywide settlements. Although Bank of America has recently back-tracked from institut-ing the fee – due to the firestorm of criticism the announcement wrought – it is a classic example of how Bank of America has over-ex-tended itself. Retail banking, which has long been Bank of America’s “bread-and-butter”, is now suffering at the hands of these acquisitions. Recent polls suggest a substantial exodus of unhappy retail custom-ers, which would be the death knell of the bank.

In October 2011, Bank of Amer-ica officially ceded its title as the world’s largest bank to JP Morgan Chase. While just a few years ago this would have appeared to be a major setback for the firm, there are many indications that this just may be a major step forward. Given the forecasts of continued slow growth in the global economy, bigger is no longer better. Bank of America’s new CEO Brian Moyni-han, who took over in January 2010, has made it explicitly clear that he will reverse the legacy left by his predecessor. In an initiative the CEO has dubbed “Project New BAC”; Moynihan has vowed to cut $5 billion in expenses by dropping

over 30,000 employees. Beyond his repeated promise of halting any new acquisitions, Moynihan must decide what stays and what goes. Bank of America has already sold off its majority stake in the Chinese Construction Bank and there are whispers of a possible Country-wide write-off. With Merrill Lynch now showing signs of profitability, it may be one of the only major acquisitions of the Lewis era to sur-vive. Regardless, Moynihan’s call for consolidation is likely to have ripple effects across the industry. With the eventual implementation of the Dodd-Frank bill and the enforce- ment of the Volcker rule being coupled with a sput- tering macro-economy, the era of the behemoth financial services conglomerates may be over. Bank of America, and its peers, will survive and thrive in the long run if they come to the realization that the industry and the economy as a whole has shifted from an era of “Too Big to Fail” to an era of “Too Big to Succeed.”

___________________________The era of the behemoth finan-cial services conglomerates may be over.

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Find out more at www.makeitrbs.com

The place is here. The time is now.

RIGHT PLACE. RIGHT TIME.

TM

hoW does hft reAlly AffeCt the fiNANCiAl

mArkets?In 2010, High Frequency Trading (HFT) accounted for 56 per cent of all equity trades in the US and 38 per cent by value in Europe, as reported by the Tabb Group, a data analysis firm. Such figures point to the huge significance of HFT to traders and investors alike. However, fierce debate has raged about HFT across the financial community. Has it benefited the market, or does it pose danger? Much of this debate has been sparked by HFT’s alleged role in the ‘Flash Crash’ of May 2010, where the Dow Jones index fell by almost 1,000 points. In this article, through examination of the machinations of HFT and its perceived positive and negative effects on financial markets, we will provide greater clarity and a holistic perspective on this vociferous debate.

By Mario Bonino & Saugata Sen

What is HFT?

HFT is the execution of trading strate-gies based on computer programmes

or algorithms to capture opportunities that may be too small for the human eye, or exist for a very short period of time. Some key characteristics of HFT are: • The investment process is completely algorithmic.• The number of orders is large compared to the numbers of trades.• Positions are often held only for few sec-onds, with no overnight open positions.• Success depends heavily on the ability to be faster than competitors.

HFT is utilised by trading firms, hedge funds, banks and brokers. Moreover, HFT is used as a method in market making, statistical arbitrage and deterministic arbitrage.

A market maker is an entity that buys and sells a particular financial instrument at the same time. The market maker hopes to profit from the bid-ask spread (the difference between the buying and sell-ing price). In other words, market makers generate profit by buying a stock at a lower price than the price at which they sell it, or selling the stock at a higher price than the price at which it was purchased.

Statistical arbitrage usually involves two financial instruments whose prices are mis-aligned in the market. Profits are obtained by buying the undervalued asset and short-ing the overvalued one. To be effective, this strategy requires powerful computational, trading, and information technology infra-structure. This strategy does not guarantee

a profit, but only an expected profit based on the assumption that the misalignment between the instruments will vanish in the future.

A deterministic arbitrage opportunity occurs when it is possible to make a sure profit. These opportunities exist for a very short period of time; therefore the use of algorithmic strategies inherent in HFT is necessary. An example of deterministic ar-bitrage occurs when there is a stock quoted on two different exchanges and the best bid price in the first market is higher than the best ask price in the other market. In this situation, one can make a sure profit by buying the stock in the second market and immediately selling it in the first market.

What are the perceived positive as-pects of HFT on financial markets?

Many analysts and academics strongly be-lieve that HFT, when used for market mak-ing or employed in a statistical arbitrage strategy, contribute to the quality of the financial markets. As outlined earlier, high-frequency traders effectively act as ‘market makers’, quoting prices at which they are willing to buy and sell stocks and shares. In order to attract trading, market mak-ers compete to offer the best quotes. Each time a market maker improves on the price offered by a rival, the spread shrinks, so investors reap more gains. HFT traders update their quotes in microseconds and consequently, spreads can shrink extremely quickly. A study of 120 shares on the NAS-DAQ concluded that HFT offered the best

buy and sell prices available, two-thirds of the time. Rapid updating also meant that HFT quotes clustered around the best price available, increasing the number of trades that took place at near-optimum prices. HFT is effectively making sure that the market clears as much as possible by attempting to reach supply and demand equilibrium of assets as quickly as pos-sible, achieving efficiency gains in the process. A greater convergence of bid and ask prices also reduces price volatility of stocks and shares, imbuing investors with greater confidence to follow through with their transactions.

As ‘de facto’ market makers, high-frequen-cy traders can exploit pricing anomalies and pick up pennies at the expense of other traders, in what was referred to ear-lier as statistical arbitrage strategies. As we have witnessed in their quest to seek trad-ing profits, competition among high-fre-quency traders serves to tighten bid-offer spreads. This reduces transactions costs for all market participants, both institutional and retail. Burton Malkiel, of Princeton University, cites lower transaction costs as a key driver in enhancing liquidity in financial markets. The convergence of bid-ask prices lowers the costs for firms processing large volumes of trade per day and this incentive subsequently serves to make such markets more liquid in nature. Due to HFT, transaction costs on an aver-age trade have decreased significantly in the last decade. For example, a retail inves-tor could pay over 1% for an average retail transaction ten years ago, while that same investor can now enter into transactions for 25 basis points (0.25%) or even less. Overall, with the measured effects of pro-moting market efficiency, reducing market volatility, spreads and transaction costs, a strong case has developed in favour of HFT as an integral element in improving market quality.

What are the perceived negative as-pects of HFT on financial markets?

When judged theoretically, HFT is a benefit to market quality and liquidity. However, in reality this is debatable. The Flash Crash on May 6th 2010 is a case in point. The Dow Jones fell in index value by almost 1,000 points, equivalent to 9% of its value. In particular, between 2:42 pm and 2:47 pm the Dow Jones Index rapidly fell by over 600 points. A July 2011 report from IOSCO (International Organization of Security Commissions) said, “[HFT technologies] usage was clearly a contrib-uting factor in the flash crash event of May

18FUNDAMENTALS | THE ANALYST

6th, 2010”. Furthermore, some analysts have even gone as far as to say that HFT was the underlying cause of the flash crash. For example, an analysis conducted by Nanex, a data analysis firm, suggested that the Flash Crash was caused by the phenomenon of quote stuffing, precipi-tated by HFT.

According to Optiver, a trading firm, quote stuffing is a strategy designed to “deliberately generate a large number of quotes or orders that competitors have to process but that the firm can ignore since they would have generated them”. By flooding the market with quotes, firms can then quickly withdraw them to gain valuable time against competitors. Lags in best bid and ask prices subsequently oc-cur, creating a vacuum and a subsequent opportunity for arbitrage.

At 14:42:46, bids from the New York Stock Exchange started crossing above the National Best Ask prices (the lowest sell-ing price available in the market) in about 100 NYSE listed stocks, expanding to over250 stocks within 2 minutes (as shown figure 1). With NYSE’s bid above the offer price at other exchanges, HFT systems would attempt to profit from this differ-ence by sending buy orders to other ex-changes and sell orders to the NYSE (i.e. deterministic arbitrage). In figure 1, the coloured lines represent the total number of stocks in different exchanges where the ask price is below the bid price.

Nanex observed that minutes later, trade executions from the NYSE started coming through in many stocks at prices slightly below the National Best Bid, setting new lows for the day. This is unexpected, because the execution prices from the NYSE should have been higher, matching NYSE’s higher bid price. Nanex argues

that this was caused by the fact that the time stamps were not reflecting when quotes and trades actually occurred. In fact, Nanex suggests that the quotes sent from the NYSE were stuck in a queue for dissemination and time stamped only when exiting the queue. The resulting fea-ture of this phenomenon is clearly shown in Figure 2.

The delay was large enough to cause sell orders to flow to the NYSE causing a downward momentum in general stock prices. When the results of these trades were published, the HFT systems detected the sudden price drop and automatically bet on capturing the developing down-ward momentum.

Figure 2: The red blocks represent the consecutive NYSE trades under the Best Bid between 14.40 and 14.50.

Conclusion

HFT may be the driving force behind equity trades in developed economies, but it has never been free from controversy. For all the virtues of lower transaction costs, increased liquidity and reduced spreads in the market, we must equally consider how such fast-paced transactions can potentially cause and exacerbate falls in the market. Irrespective of the flash crash, HFT has become so heavily integrated in trading strategies that we are far beyond the point of no return. Despite strong criticism of causing greater uncertainty and volatility in stock exchanges amid the flash crash, 20 minutes of near-collapse will not re-place the 10 years of greater speed, efficiency and value that HFT has created for investors. Even if we examine the facts in granular detail, few can doubt the importance of HFT to trading firms across the major economies. The real disaster would be to have a narrow view of HFT, that all benefits of its use are dismissed.

Figure 1: The green line shows the total number of NYSE listed stocks where the ex-change’s Ask price is below the Best bid price.

19 HOW DOES HFT REALLY AFFECT THE FINANCIAL MARKETS?

privAte equity: the roAd

AheAd“We have got to move out of the shadows and open up to scrutiny and regulation. It’s not that tough. And actually it’s a good discipline.”-- Jonathan Russell Global Head of Buyouts, 3i

By Atin Dhawan

20

The Private Equity (PE) asset class came to prominence in the 1980s at

a time where the prevailing corporate structure was the conglomerate (a large corporation formed by the merging of separate and diverse firms). Managers ran companies with limited economic stake in the stock of companies, and where a great deal of judgment of performance was in the realization of management earning goals which did not always coincide with those of the shareholder. Accounting earnings is a company’s net income as reported on its annual report calculated by any method approved in the Generally Accepted Accounting Princi-ples (GAAP) standards. The flexibility of these accounting methods allows some to be selected specifically for their favorable portrayal of company growth.

In contrast, the earnings before inter-est, tax, depreciation and amortization (EBITDA) measure is purported to reflect ‘cash earnings.’ This is a non-GAAP met-ric, without accrual accounting, canceling tax effects and the effects of different capital structures.

PE houses typically seek out underper-forming companies with strong free cash flow generation, stable market position and a scope for operational improve-ments. A simple outlay of the ‘Private Equity’ business plan then, is for a PE firm to invest long-term capital compris-ing of a substantial portion of debt with the remainder being equity provided by the PE firm (typically in a ratio of 70:30) into companies. Once under PE owner-ship, the company undergoes significant restructuring including subsidiary sales and operational improvements under the guidance and expertise of the PE firm.

For a PE firm debt is a key component in the purchase price when considering a company. The reasons for such high levels of debt are so the PE firm can realize an acceptable return on its relatively small equity investment (typically 20%-25%).

Tax payments are also reduced via the tax shield on the interest of debt payments. Once the company is under such owner-ship, its yearly free cash flow is used to pay down debt. Debt repayment increases equity value on a dollar for dollar basis. Once a substantial portion of debt has been paid down, typically in the fifth year from investment, the PE firm seeks to exit at a profit typically by selling the compa-ny at a higher enterprise value (EV) than it was initially acquired for. Some of this profit is used to pay off debt further, while the remainder is kept as retained earnings for the PE firm. This investment strategy amongst PE houses is most common and referred to as a “Leveraged buyout” (LBO). Another strategy which has risen to prominence recently is the Venture Capital, where financing is provided to early-stage high-risk start up companies. Here the fund makes money by owning equity in the companies it invests in.

Today there are vast numbers of PE firms with varying fund sizes and investment philosophies; some of the most well known include Kohlberg Kravis Roberts, Blackstone, and Apollo Capital Manage-ment.

During the boom years of PE, more than $700bn was committed to the industry from 2006 to 2007 and deal volume grew exponentially from 2001 to 2007. The in-

dustry was moving upwards and onwardsMegadeals were on the cards and fundraising was at an all time high. Nothing seemed to stand in the way of this burgeon-ing asset class. Then came the recession of 2008.

In the fall of 2008, the world suffered a catastrophic credit crunch. In the wake of the financial crisis, we saw the termination of financial powerhouses from bulge bracket Investment Banks to Insurance giants. The global financial crisis also had a vast impact on PE, given PE firms’ dependence on In-vestment Banks for the debt portion of their investment. Due to a reluctance to engage in financing acquisitions with PE firms and coupled with the banks’ own challenges, it is no surprise then the PE industry is expected to face hurdles in the future.

Industry ChallengesIn particular, the three key issues facing the Private Equity industry pertain to the evapo-ration of bank debt, funding and regulation.

As discussed with regards to an LBO, a key component in PE takeovers is bank debt. Post crisis, bank debt has all but vanished as banks undergo a restructuring of their balance sheets, and costs of debt continue to soar. Since bank debt has become more limited, deals have become scant. Accord-ing to Deutsche Bank research, June 2007 saw buyouts announced in excess of $120bn, whereas for the same period in 2009, that fig-ure was $9bn. The lack of cheap debt will see the industry shrink significantly in the next five years. A result of this is the likelihood of increased equity contributions to deals with more focus on mid market opportunities. Data from The Centre for Management Buy-out Research shows that in the 3rd quarter of 2010, equity contributions exceeded 60%, as opposed to their 20% average during 2005-2008.

A large number of PE firms need to raise

FUNDAMENTALS | THE ANALYST

capital for new investment funds but given the low commitments from endowments, pension funds and with the expected poor performance of recent investments; only the very best firms will overcome this chal-lenge. The problem may also be augmented by a number of sovereign wealth funds that have decided to bypass PE and di-rectly strike out on their own. An unstable economy and volatile market are enough to add to the uneasiness of investors but in an industry that requires investor funds to be tied up for many years, it is a further tough sell.

Data provided by Pitchbook shows an emergence of the era of the ‘mini funds’ where most recently in 2010, US funds had the lowest percentage of capital raised by size than in prior years.

Regulatory tightening The PE industry has been relatively isolated from financial regulation, how-ever in light of the world financial crisis, regulation has been under the spotlight and several new proposals will affect PE. In particular, the European Union Directive for Alternative Investment Fund Managers (AIFM) is of importance. The AIFM is a EU law that will put Private Equity funds under the supervision of a EU regulatory body. Key items of the AIFM proposal impacting on PE include:

• An independent valuer of the private equity fund• A private equity fund must disclose its business plan for a portfolio company to that company, its shareholders and em-ployees as well as make that information public• A limit to leverage for one time the amount of capital across a fund

Adherence to such requirements and more will have significant impact on both fund- raising and investment philosophies of private equity funds. Research from think tank ‘Open Europe’ has indicated that the hedge fund and PE industry contribute €9.2 billion in tax revenues to the EU economy every year, which would come under threat if the EU’s AIFM directive would have been passed in its original flawed form. Nevertheless the European Parliament voted through a final text of the directive on 11th November 2010. Given that the intention is to introduce the direc-tive in 2011, this gives funds very little time to implement the changes required to their systems and business model.

Bye, Bye MegadealsGiven the rising cost of capital, tightening credit standards and regulatory grip, an ad-justment of expectations is necessary from investors who can no longer expect the massive gains from earlier in the decade to continue. What we will see is a significant rise in deal activity in the middle mar-ket, as financing for ‘mega deals’ seems too risky and even unachievable as debt markets unwind. 2011 has already seen a period of smaller deal activity. Pitchbook reports during the 1st quarter of 2011, more than 40% of the deals closed by PE firms were valued below $50m and nearly 80% below $250m.

PE will also continue to face pressure from the strategic buyer. Buyers competing in the same sector as the target can acquire it with an all cash transaction, and hence avoid leveraging the target. Such buyers may also provide a more compelling case for takeover of a firm in the same industry

it is in, than a PE firm perhaps might.

Emerging Alternative? Emerging markets perhaps offer an alterna-tive route for PE. It would not be surprising to see more and more investments funnel their way into such regions in the future. Companies in developing markets tend to enjoy favorable demographics and in order to exploit growth opportunities and new markets they must open up to the global economy. The less developed regulatory and legal systems in these countries will be of big appeal to PE firms looking to escape increasing regulatory pressures at home. Many of these companies, although with access to local sources of investment, such local sources often lack the value adding capital and operational improvements that only experienced PE firms can deliver. PE firms can implement their managerial know-how and supervision to help such companies expand internationally. Even though PE investment outside the US and Europe through 2003 to 2007 accounted for only 5% of their $600bn or so of in-vested equity, these growing markets will demand PE involvement and recent trends indicate that PE is starting to turn its atten-tion and fund raising efforts to emerging markets. For example in India, Tata Capital announced commitments of up to $800m for its own private equity fund. Similarly in China, Goldman Sachs has established a Yuan denominated fund to invest in China.

OutlookThe PE industry still has a vast sum avail-able for investment from earlier fund rais-ing known as ‘dry powder.’ Indeed, Prequin a research group found such ‘dry powder’ to be in the region of $477bn in 2010. This is by no means a small number, given the vast majority of deals in the near future are likely to be middle market. This overhang will need to be invested soon has investors become impatient for returns.

PE still remains an asset class in the growth stages. Deutsche Bank research estimates PE to account for only 3% of the market capitalization value for both global equities and bonds.

While deal flow has had a significant decline, as of Q3 2011, buyout activity was up 7% from Q1 2011 and well above the average $55bn per quarter in 2010. But as markets continue to stay unpredictable and bank debt remains scarce, the absence of mega deals will continue. However there are plenty of small and mid-market deals for PE powerhouses to get stuck into, until a prolonged period of market stability and confidence re-emerge.

21 PRIVATE EQUITY: THE ROAD AHEAD

tough times for NAtioNAl stoCk

exChANgesThe image of national stock exchanges etched into the mind of many, of men frantically yelling across a crowded trading floor, has dimin-ished. Constantly reinventing themselves, exchanges have evolved from publishing share prices on a 10-by-4-inch sheet of paper, to the automated trading systems of today. Integral in value creation for economies, they have held a unique position that was rarely chal-lenged. For some, the stock exchange is a badge of national pride; for others it is a symbol of capitalism, which most associate with liberty and democracy. Nevertheless, over the last decade, certain factors have prompted significant changes to the landscape in which stock exchanges operate. This article explores the impact and reaction of national stock exchanges to regulation, technology and globalisation.

MiFID

The European Markets in Financial Instruments Directive (MiFID) came

into effect on 1st November 2007, replac-ing the Investment Services Directive (ISD), which aimed to harmonise the legislation governing investment services across European member states. As stated by the FSA, one of the fundamental aims of MiFID is to ‘foster competition and a level-playing field between Europe’s trading venues for financial instruments’. The rules have allowed alternative trading venues, known as multilateral trading facilities (MTF) to come into existence. MTFs enable traders to access European markets in a single currency and on one trading platform. One such example is Chi-X, which has experienced a signifi-cant growth in market share to become the largest exchange in Europe by value traded in EU and Swiss stocks, according to Thomson Reuters Equity Market Share Reporter. Chi-X established itself as an MTF in 2007 and gives traders access to 1300 financial instruments on 15 national exchanges. Like other MTFs, the com-pany’s value proposition is to offer lower latency (the time taken to execute trades) and higher trading capacity. Chi-X, along with other MTFs, offers a low-cost pricing structure that pays members who bring liquidity to the platform (for example, market makers) and charges a fee to those who take liquidity.

The arrival of MTFs in the exchange market has eroded the market share of the incumbent stock exchanges, resulting in calls by national stock exchanges to

develop “sustainable business models in a complex and dynamic industry”, accord-ing to Nicolas Bertrand, head of equities and derivatives markets for the London Stock Exchange. The LSE’s market share fell below 50% in April 2011 for the first time in its 210-year history. Since the arrival of the current CEO, Xavier Rolet, the firm has commenced a strategy to diversify its revenue sources, improve its trading platform and identify opportuni-ties to expand.

http://www.efinancialnews.com/share/me-dia/images/2010/05/4063111949.gif

Technology

With the shift away from open-outcry trading floors toward electronic trading platforms, stock exchanges no longer only compete for lower prices, but to attain the lowest latency in the market. The ability to trade electronically coupled with an increasingly fragmented market has led to the emergence of high frequency traders, who use complex algorithms to make a large number of trades within a matter of microseconds, often to exploit arbitrage

By Jankee Gohil & Shu Hang Low

opportunities. According to research by the TABB Group, 38% of equity trades in Europe and 56% of equity trades in the US were made by high frequency traders in 2010. Thus, technical progress has the potential to bring big business to exchanges. In order to compete with the MTFs, national stock exchanges must secure the capacity to make the fastest possible trades in this competi-tive environment. In an attempt to reassert its position in 2009, the LSE acquired Sri Lanka-based IT company, MillenniumIT and has since begun to migrate all of its mar-kets to the platform. This is estimated to save the LSE £10m in FY 2011-12. Turquoise, the MTF part owned by the LSE Group, has migrated to the MillenniumIT platform and is said to deliver an average latency of 125 microseconds; LSE claims it is the fastest trading platform in the world.

Exchanges also maintain revenue streams from selling their trading platform abroad. The LSE recently secured a deal to imple-ment the MillenniumIT system at the Delhi Stock Exchange. Similarly, in 2010, the Nasdaq delivered its trading platform to the Singapore Stock Exchange, SGX.

New technology does not come without its problems. On 25th February, the LSE expe-rienced a glitch in its system that suspended trading for 4.5hours, following similar issues on the LSE’s Turquoise and Boursa Italiana earlier in the year. As one trading technology company director explained, “Technology is

just such a crucial part of the exchange space now. The LSE has to absolutely prove the MIT platform is fit for purpose and for anyone else who might want to buy it”.

Exchanges are also fighting competition using a more traditional method – getting bigger. Indeed, the decade has witnessed the expansion of American and European ex-

changes. In September 2011, the LSE placed a bid for LCH.Clearnet, the UK-based clear-ing house in an attempt to establish clearing capabilities for its UK equity trades and to assist with the aim to expand its derivatives offering. Aside from this, small MTFs are frequently purchased by exchanges for the purpose of reducing competition, absorbing the MTF’s technology and expanding their product roster.

However, it is the mooted consolidation between major national exchanges that have attracted the most attention. Within the last

Consolidation of Exchanges

22FUNDAMENTALS | THE ANALYST

year, the world has witnessed numerous merger proposals of unprecedented pro-portions. One factor spurring this phe-nomenon is the increasingly global view of investors. Reduced information and trans-action costs in overseas markets coupled with the gradual removal of geo-political and regulatory barriers to cross-border transactions have triggered demand for a global pool of liquidity. Another benefit of consolidating is the creation of economies of scale, the main driver behind the NYSE Euronext-Deutsche Borse deal. The merger will give rise to a single compatible trading platform, yielding synergies of €300m per year. Combined resources will also lead to better technological facilities, making the entity more competitive in terms of price and speed. In addition, the merger would cut customer expenses in maintaining disparate connections and risk monitoring systems. This will no doubt attract new in-vestors, leading to higher trading volumes and more importantly, heightened market liquidity.

Unfortunately, many of the consolidation plans have resulted in disappointment. The LSE was forced to abandon its £2.3 billion plan to merge with TMX in June due to intervention by The Maple Group - a con-sortium of Canadian banks and pension

funds who derived its name from Canada’s patriotic maple leaf. They offered a sweet-ened counter-bid with the motivation of protecting the sovereignty of Canada’s se-curities market. SGX encountered a similar obstacle in April, when its A$8.4billion bid for its Australian rival was rejected by the government amid resistance from nationalist politicians, with the govern-ment eventually claiming the deal was not in the national interest. On the other hand, the NYSE/Deustche Borse deal has yet to receive the green light from EU regula-tors due to concerns over the monopoly on exchanged-based futures trading in Europe that the combined company would have. Nevertheless, the trend of exchange consolidation is in its infancy and experts believe that in the future, the industry will be dominated by a mere few transnational conglomerates. Exchanges around the world are now racing to fill the market gap of a truly global trading platform.

The Future of National Exchanges

Like any other company, exchanges must respond to the needs of market partici-pants and the dynamic economic envi-ronment. With the concept of national boundaries murkier than ever, investors

are starting to view purely national stock exchanges as archaic. While these institu-tions will no doubt remain a fundamen-tal part of financial infrastructure, the clout they have in the market place in the next decade is dependent on their abil-ity to adapt to this highly globalised and competitive business. The second wave of European regulations (dubbed “MiFID II”) has as one of its core aims the increase of transparency in the market place. The result of the current debate about bringing trade transparency to dark pools (net-works that enable very large trades to be completed internally and off-exchange to minimise market impact) and regulating over-the-counter derivatives are likely to have similar consequences for the national exchanges operating in Europe as well as the pan-European MTFs.

23 TOUGH TIMES FOR NATIONAL STOCK EXCHANGES

the CorrelAtioN betWeeN Cds

CoNtrACts ANd Credit

spreAd Curves

Introduction

In an era of financial instability crippling the troubled Eurozone, the financial

press often reports the prices of credit default swaps (CDS) contracts and bond yields of the aptly termed ‘PIIGS’. This acands for Portugal, Ireland, Italy, Greece and Spain, all of whom are characterro-nym stized by significant issues sur-rounding their sovereign debt. In this article This article will demonstrate how CDS prices and yield curves can be used to “price” the credit risk of a country. Moreover, it can be demonstrated that a strong correlation exists between them.

According to the International Swaps and Derivatives Association, “A credit default swap is a credit derivative contract in which one party (protection buyer) pays a periodic fee to another party (protec-tion seller) in return for compensation for default (or similar credit event) by a

reference entity. The reference entity is not a party to the credit default swap. It is not necessary for the protection buyer to suffer an actual loss to be eligible for compensation if a credit event occurs.” So, a CDS contract offers protection against the default of corporate or sovereign debt. Since the seller of the CDS is taking a risk, the buyer of the contract has to compen-sate this risk by paying a periodic fee. This fee is negotiated at the time of contract settlement. Therefore, this is a measure of the credit risk of the reference entity. If the default of the entity is measured as likely, the annual fee will be very high. On the contrary, if default is unlikely, the fee will be low. For example, if one wants to buy protection against an Italian default for five years, the annual fee is around 500 bps (basis points). This means that to insure 10000€, the buyer has to pay 500€ each year. In the event of a default, the seller gives the buyer 10000€. The annual fee is called “CDS spread” and it is

Figure 1: Historical prices of 5-year Italian CDS.

By Mario Bonino

a measure of the credit risk of an entity (see Figure 1).

Another measure of credit risk is provided by yield curves. The yield curve of a particular entity represents the yield-to-maturity rates of the bonds of that entity for different ma-turities, usually between three months and thirty years. The yield-to-maturity of a bond (often referred simply as yield) is the internal rate of return earned by the buyer of a bond at the market price and the receipt of all scheduled future payments. Written formu-laically, the yield-to-maturity of a bond is the number R that satisfies the equation

where

-t is the current time -Pt is the current market price of the bond -C1,…,cn are the future payments of the bond, such as the payment c_iis given at time ti, so that t<t1<...<tn -yi is the amount of time between t and ti, expressed as a year fraction

The yield-to-maturity is an instrument to evaluate bonds and, when an investor is measuring the relative cost of a bond, one would usually analyse its yield-to-maturity.

The yield curves can also be used to evalu-ate credit risk. In fact, consider these two investment strategies. Firstly, a yearly coupon at a fixed rate. Since the investor is weary of a possible default of the issuer, they also buy a 5 years CDS contract. Another investor purchases a 5 year risk-free bond (assuming a perfect world).

See Figure 2 on the next page.

Since in the first scenario the credit risk of the issuer is neutralized by the CDS protec-tion, these two strategies are identical. There-fore, the return that they can achieve with them should be the same. In formulas,

where

-Rr is the yield of the risky bond -Rrf is the yield of the risk-free bond -CDSspread is the annual CDS spread.

We can manipulate the formula to obtain

FUNDAMENTALS | THE ANALYST 24

Figure 2: Italian yield curve on 27th October 2011

Therefore, the 5 year CDS spread should be equal to the difference between the 5 year risky yield and the 5 year risk-free yield. The latter is termed the yield spread. This logic can be applied to not only 5 year bonds and CDSs, but also other maturities. Ergo, it is evident that there exists a very strong relationship between CDS spreads and yield spreads. This connection is pre-sent in real financial markets, as demon-strated in the following chart (Figure 3). Since no risk-free asset exists in reality, the German Bunds have been used as a proxy, since they are considered the safest bonds in the EU bond market.

Figure 3: Italian 5 year CDS prices versus Italian 5 year credit spread, daily data from 29th March 2010 to 10th October 2011.

To measure the correlation between these two quantities, we can calculate the cor-relation coefficient, which is defined as

where

-COV indicates the Covariance - Yield represents the standard deviation of the yield spread - CDS represents the standard deviation of the CDS spread

If we compute an empirical estimation of the correlation coefficient, we have that

Therefore, historical data confirm a very strong correlation between these two quantities.

However, this correlation seems to reduce

in the advent of certain events, for example when the ECB announced that it was going to buy Italian bonds during Fall 2010 and August 2011. This market reaction is evident in Figure 4.

To conclude this analysis, it is worth noting that yield spreads are usually the driv-ing factor between CDS prices and yield spreads. In fact, the bond market islarger than the CDS market, so, the meas-

ure of risk provided by it should be more precise. However, the break in correlation is evidence that at times, CDS prices do not follow the yield spreads closely.

Figure 4: 20-day window rolling correlation coefficient. At each date, the value in the y-axis represents the correlation coefficient calculated over the last 20 days. This shows how the correlations behaves over time. We can see a big drop in correlation in both Fall 2010 (beteween September and August) and August 2011.

To conclude this analysis, it is worth not-ing that yield spreads are usually the driv-ing factor between CDS prices and yield spreads. In fact, the bond market is larger than the CDS market, so, the measure of risk provided by it should be more precise. However, the break in correlation is evi-dence that at times, CDS prices do not fol-low the yield spreads closely. This theory is supported by the fact that recently, the ECB interventions have been relatively small, so they are not utilised to solve the Euro zone debt problem, but only to lower the yields when they approach unsustain-able levels. T break in correlation is a way by which the market prices the fact that the inverventions are only temporary and therefore do not impact the credit risk of the sovereign countries.

25 THE CORRELATION BETWEEN CDS CONTRACTS AND CREDIT SPREAD CURVES

quANtitAtive eAsiNg: more of the sAme

gAme?“We did that because the news from the rest of the world in the past few months has been very poor” were the words of Sir Mervyn King, Governor of the Bank of England, as the Bank announced a further round of quantitative easing, (QE) worth £75 billion, commencing in October 2011. As fears have risen that the developed world might be tipping back into recession amid troubles in the Eurozone, the spot-light is now on policymakers to avoid another debacle. Here we are now playing the same game. But surely, is there not another game we could play?

What is QE, and how does it work?

In March 2009, the Monetary Policy Committee announced that in addition

to setting the Bank Rate at 0.5%, it would start to inject money directly into the economy to meet the inflation target. The MPC’s decision does not involve printing more banknotes. Instead, the Bank buys assets from private sector institutions and credits the seller’s bank account. The end result is more money out into the wider economy. The MPC can opt to buy a variety of assets, and in March 2009, it decided to mainly buy UK government bonds (gilts).

Direct injections of money into the economy can have a number of effects. The sellers of the assets have more money to spend. Or they may buy other assets instead, such as shares or company bonds. This has the effect of pushing up prices of those assets, creating a perceived wealth effect for the owners. Higher asset prices mean lower yields, reducing the cost of borrowing for businesses and households. In addition, banks will find themselves holding more reserves. That might lead them to boost their lending to consumers and businesses.

So, has it been a success in the UK, and do we really need more?

In a recent study, the Bank of England esti-mated that QE had raised real GDP by 1.5-2%, while increasing inflation by 0.75-1.5%. However, analysts are divided on whether the policy was successful. The UK exited recession, but was the last major economy to do so. Initially the growth rate was very slow, at a mere 0.1%. It then improved with the economy growing by a credible 1.2% be-tween April and June 2010. This growth rate was not sustained, as the economy shrank by 0.5% in the last three months of 2010, and has recorded weak growth since. Some have suggested that QE has buoyed the financial markets by suppressing the interest rate on government bonds. However, others argue that lending to businesses and individuals is still sluggish.

Sushil Wadhwani, a former member of the MPC, criticises QE as an ineffective policy measure, especially in light of the Bank’s recent forecasts. With the ultimate aim of boosting lending, Wadhwani believes that, ‘ultimately, unconventional monetary policy will be successful only if it boosts economic activity. Getting the equity market – and thereby business and consumer confidence – sustainably higher should be central to authorities’ strategy – QE does not achieve this’. QE may well have raised GDP, but only its nominal, not real value. M4 lending fig-ures since the start of QE has fallen short of expectations (see figure 2 on next page). This only begs the question, will more really help?

The launch of the latest round of quantita-tive easing in the UK has seen cracks emerge already. One commercial bank was repri-manded by the Bank of England for squeez-ing gilt prices higher ahead of the first QE auction held in October, known as market manipulation. This is where a bank buys gilts ahead of an auction, in this case the 8.75% gilt maturing in 2017 as in figure 1, to push the price higher. It then sells the asset to the Bank at a profit.

This is indicative of future problems, as gilts become scarcer; forcing the Bank to buy at increasingly higher prices and lower yields. Andrew Roberts, head of European rates strategy at RBS argues that, “There is a law of diminishing returns. As QE goes on, the less bang the Bank of England gets for its buck – and the greater the risk of manipulation.” As seen in figure 1, with a substantial share of gilts already purchased, further purchases pose the risk of market distortions, or con-versely having no impact at all.

The limits of QE are underlined by the fact Figure 1: Market manipulation and the gilts already purchased.

By Saugata Sen

FUNDAMENTALS | THE ANALYST 26

that the Bank is not prepared to purchase a large amount of corporate bonds due to its wariness of absorbing credit risk onto its balance sheet. In total, it has bought less than £1bn in corporate bonds. Rich-ard Batty, investment director at Standard Life Investments, says: “There will come a point when QE purchases must come to an end as there is a finite supply of gilts, but the Bank of England does not want to buy corporate debt.”

So, what else can we do?

Many market participants feel there will come a time when the Bank takes the risk and acquires corporate bonds onto its bal-ance sheet. A new line of attack with the

Figure 2: M4 Lending up to September 2011.

same instrument may elicit the confidence boost QE is desperately seeking in stock markets. The scale of the purchases need not be grandiose, just the signal of trying something new may ignite weak lend-ing levels. Figure 2 shows the latest M4 lending figures for the UK. M4 excluding OFCs (money held that is unlikely to be a medium of exchange) has been fairly stagnant this year, and with QE reaching its gilt-buying limits, buying corporate bonds may well become more pronounced in the future.

If the Bank of England does not want to incorporate such risks onto its bal-ance sheet, then it may take notice of the Federal Reserve’s new approach, Opera-tion Twist. Operation Twist attempts to

push down long-term interest rates by selling short-term bonds on its balance sheet, and replacing them with longer-term debt. The Fed has officially stated that the programme was aimed at reducing the cost of borrowing for businesses and consum-ers, including the cost of mortgage loans. However, the failure of equities to rally after Operation Twist in the US hints at the possibility that unconventional market policy does not have a predictable or posi-tive effect on stock prices.

If QE does not offer firms improved credit access during times of deleveraging, then a policy of credit easing may be the way for-ward. George Osborne unveiled this plan in November 2011. Credit easing would

involve using billions of pounds of public finance to buy corporate bonds, issued by small-to-medium sized enterprises (SME’s). The purchase of corporate debt could, in theory, be carried out on behalf of the Treasury by the Bank of England, but the risk would sit on the Treasury’s bal-ance sheet. In the longer term, the impact of credit easing on the flow of credit to smaller businesses could be more signifi-cant as the Treasury hopes to encourage the creation of bonds made out of small-business loans, by promising to buy such bonds and create a market for them for sophisticated investors.

In theory, such a scheme would ensure easier access to cheap finance for SME’s. However, some may feel uneasy that this potential harmonisation of monetary and fiscal policy is heading toward unchartered

and dangerous territory. Moreover, the major cause for concern is that this glosses over key structural reforms needed in credit markets to ensure governments need not actively prop-up weak lending levels.

Conclusion

QE is clearly not working. More of the same game will inevitably lead to more of the same pain. The recurrent failures of QE thus far have been weak lending and busi-ness confidence levels; the exact predica-ments QE was meant to combat. The differ-ent remedies explored have led us into two paths; one of continued gilt purchases with a twist and the other of targeting corporate bonds through two different institutions (the Bank against the Treasury). However, regardless of which mechanism offers the best alternative, the path we are currently following needs to be diverted. Let us hope that in the near future, the UK economy is playing a new game.

27 QUANTITATIVE EASING: MORE OF THE SAME GAME?

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BAR_417547_297x210_escalator.indd 1 7/7/11 10:09:25

hoW to seCure thAt

Coveted iNterNship?

It is now the recruiting season for stu-dents looking to land an internship spot

at one of the prestigious banks and other firms, and it is often a period of much stress and pressure. To give you some insight and advice with regards to the ap-plication process as well as the internship experience, our team has met up with four LSE students who completed their intern-ships over the past summer.

They are:

• Jankee Gohil London Stock Exchange (LSE) - Finance Division

• Max Fallstrom J.P. Morgan IBD - Industrials

• Natasha Ratanshi Goldman Sachs IBD - Natural resources

• Andrew JacksonBarclays Capital - Credit Risk Manage-ment

1.How much training did you re-ceive at the beginning of the intern-ship?

• Max (J.P. Morgan): I received one week of training including: Two days of ac-counting/finance, some training in J.P. Morgan’s internal systems and a session at FactSet’s (a data provider) London office.

• Jankee (LSE): Before the internship started, the interns were sent various documents to read through; these were the LSE annual report, a guide to listing on the Exchange, an investor relations guide and a consultation document on the Markets in Financial Instruments Direc-tive (“MiFID”). On the first day of the internship we were given presentations by 5 managers about their departments and relevant topical issues. In the Finance Division, the tax managers gave a pres-entation on relevant aspects of tax, which covered corporation tax, VAT and inter-national tax treaties. Every week we were given a breakfast briefing from a manager of a different division in the company.

• Andrew (Barclays): I had a one-week markets training along with all the other interns. The training covered pretty much everything about everything from Foreign Exchange to commodities to fixed income, all in one week so it was rather intense. I also had one day of social skills training.

2. What did you do during the internship ? What was your project about and how was the outcome?

• Andrew (Barclays): I spent half of my internship on the Corporates team and the other half on the Financial Institutions team. My main responsibility was to write reviews on clients in order to assess the credit risks involved with doing business with a given company. The aim of writ-ing these reviews is to recommend credit limits to senior risk managers. I also had to write the daily news update for the Power, Utilities and Infrastructure sector; so every morning I would go over all the relevant news on the sector and would then send out a summary to my team.

• Jankee (LSE): Since I was working in the Finance Division, my first project consist-ed of assisting the Tax team with a Group restructuring project. I observed meetings, took minutes and created an outline for the project. I also attended a consultation session on the HMRC’s new Controlled Foreign Companies reform, which was crucial to understanding the aim of the re-structuring project. I assisted in a transfer pricing exercise for a transaction between the LSE and Borsa Italiana (the Italian stock exchange, which is owned by the LSE) as well as with tax computations.

I assisted the accounting team to match and reconcile intercompany accounts. Manually matching transactions was extremely useful preparation for the pro-ject that took up most of my time for the remainder of the internship. This project aimed to automate the manual matching of intercompany data using a program called UnaVista (a product that the LSE sells). I was required to learn how to use the program and analyse the data to create

By Mai Le & Ryan Zaranyika

matching rules on UnaVista. Additional-ly, the interns were given a group project that lasted for the duration of the intern-ship on potential cross selling opportuni-ties for the company. In the last week of the internship, we presented to a group of managers and graduates and participated in a mock sales pitch/negotiation.

3. What was the most challenging aspect of your internship and how did you overcome this?

• Max (J.P. Morgan): The hardest thing about IBD is probably the hours. There are obviously things that you can do to help with this such as making the most of your few hours of sleep per night, catch up on rest during the weekend.Otherwise if you don’t have a strong finance background and lots of experi-ence with Excel etc. (of which I have neither), you are expected to learn a lot fairly quickly.

• Jankee (LSE): My biggest challenge came when preparing the presentation to managers. One of the products I was presenting on was UnaVista. Although I had been using the program’s matching and reconciliation function, I was not very familiar with it’s function as a swaps portal between hedge funds and brokers. I spoke with one of the graduates work-ing in UnaVista to understand what the swaps portal does. Since the program is used in quite complex transactions, he simplified it as much as possible. The day before the presentation, I approached one of the managers I was familiar with in UnaVista to ask a particular question. It became clear to him very quickly that my understanding of what the UnaVista swaps portal does was over-simplified. He recommended I speak to another manag-er in the department to fill the gaps in my knowledge. I had to quickly understand what the product does by speaking to col-leagues as well as doing my own research and then amending my presentation.

4. Since completing your intern-ship, how has your view and un-derstanding of your business area changed?

• Max (J.P. Morgan): I had a fairly good idea of how these places operate before I started but the view is definitely different from the inside. How the different pieces of corporate finance - broking, capital markets, M&A all fit together in practice has for example become more clear.

HOW TO SECURE THAT CONVETED INTERNSHIP?29

• Andrew (Barclays): I really enjoyed Risk Management, you really get to know an industry inside out as well as the compa-nies you cover. It’s also one of those roles where you really do interact with all other parts of the bank. My understanding of Risk Management has changed in the sense that I expected there to be a ton of hardcore mathematical risk metrics, and sure there are parts of risk management that do involve highly technical concepts, but most of the time it just comes down to common sense.

5. What advice would you give to future students starting spring or summer internships?

• Natasha (Goldman): Be proactive- try to always be ahead of the game. For example, if staffed on a company project with one of the vice-presidents, make sure you un-derstand the company that you’re working on inside out. Also, if you are going to be doing work which is centralized around a particular topic do your research and make sure you fully understand the complexi-ties of the concept in order to improve the quality and usefulness of the work your producing. No matter what you are study-ing don’t be afraid to tackle things. E.g. people doing engineering/scientific sub-jects tend to be more hesitant when faced with direct finance problems. However, through curiosity, and the support around you, there is always a way to tackle any problem that you are faced with.

• Andrew (Barclays): Just be yourself; show that you are willing to learn and that you are enthusiastic. Try to contribute; for example if you see something in a news-

paper that might be relevant bring it up and engage with your team; they love it when they see that you are really interested and you can take a step back to see the bigger picture. Having said that, don’t be cocky and don’t try to show that you know everything simply because... you don’t. No matter how much preparation you do and how much knowledge you think you have, whoever you start working with will know more and will be able to tell when you are trying to blag your way through. Just be humble and hard working.

6. What should an intern do to be of-fered a place for next year internship or full time position?

• Max (J.P. Morgan): In my opinion, re-search is fundamental to securing a place on an internship or a full-time position. At the assessment center, I was required to give a presentation on the role of exchang-es. I believe that the depth of my research was apparent during the assessment center. Preparing for competency questions is also very important. Lastly, if you don’t get the internship or position you want, don’t give up! Keep researching and applying to others all year round and something will come up.

• Natasha (Goldman): Really be proactive and get along with your team. Try to find out perhaps what your team members are into outside of work and what makes them tick. Furthermore, with regards to interviews; don’t get stressed, be calm. Practicing is key and good resources to use for preparation are the Vault Guides and LSE Careers’ mock interview sessions.

• Andrew (Barclays): When you apply to a company, make sure you know that com-

pany well and why you want to work for that company. Copying and pasting your applications will only get you so far; Hu-man Resources have very talented people who are very good at telling whether your application is genuine or not. So custom-ize you applications, dig into that annual report (which you can find in the investor relations section of a company’s website) and pick out those interesting facts that will show recruiters you have done your homework. Finally, don’t fail the numerical tests - practice them using websites such as Assessment Day (yes you have to pay but in the grand scheme of things it’s not that much).

Conclusion

It is clear that graduate recruitment not only within the financial industry but also other key sectors such as law, government and media are increasingly turning to-wards internal hiring through internships. A survey published in 2011 by Martin Birchall, Managing Director of High Fliers Research, showed that interns will get one third of overall graduate jobs. As suggested by our interviewees, research and prepara-tion is key to landing a coveted internship. While this is often a stressful period for students applying for internships, give yourself an advantage over the competi-tion by taking the advice given by our interviewees who have gained first-hand experience. Good luck and all the best with your applications!

30CAREERS | THE ANALYST

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