1 VOL. XXI, NO. 19 / May 14, 2012 In This Issue At Press Time Investors Bullish On MS 2 News BNP Sees EM/U.S. Correlation 4 Barriers Triggered On EUR Drop 5 Asia Pacific SocGen Eyes Equity Structure 6 Japan Issues Clearing Rules 7 People & Firms DB Loses Derivatives Bigwig 7 Departments Learning Curve 8 Sovereign Credit Markets 11 Top Stories Unique Fixed Annuity Structure Emerges Security Benefit Life has teamed up with the Royal Bank of Scotland to market uncapped returns of the RBS Annuity Linked TVI Index, a multi-asset index with a volatility control mechanism. The agreement represents the marker of a trend by insurance companies to move away from marketing variable towards fixed indexed annuities, a more conservative investment which requires a different type of derivatives hedge. Normally, variable annuity exposure would be hedged by variance swaps. Fixed indexed annuity exposure in this case is being hedged by a volatility control mechanism on the TVI index, the first volatility-controlled investment created specifically for an insurance company, said Michael Nelskyla, head of equity derivative sales for the Americas. Part of the reason RBS is first to market with this is its exclusive agreement to provide calculations and data distribution for the TVI Index with EAM Partners, Michael Nelskyla creators and owners of the index. Doug Wolff, president of SBL in Topeka, Kansas, told DI the firm prefers fixed indexed annuities over variable annuities because there is less downside risk and they are easier to hedge. SBL is marketing the ALTVI exposure as one of three options for investors in a new (continued on page 11) Labor Dept. Rules Could Snag Clearing The U.S. Department of Labor rules regarding prohibited transactions and fiduciary obligations will make it tough for swap dealers to clear over-thecounter swaps for pension plans under Dodd-Frank if guidance or exemptions are not provided. Implementation is slated for November and DoL often acts with glacial speed, which has the industry very concerned. The issue is that swap dealers entering into cleared swaps with pension plans will run the risk of breaching ERISA fiduciary obligations should they have to close out swaps with defaulting pension counterparties. Over the past decade several airlines have defaulted on their pension plans, including a USD9 billion dollar default by United Airlines in As it stands, the DoL has in place CS To Go Institutional On Index Structures In Japan Credit Suisse is preparing to roll out structured products to Japanese institutional investors that reference the firm s new Emerging Markets Focused fx index. The move is aimed at tapping pent up demand after local regulators called for greater transparency in popular, but risky, combined emerging market and fx structures, commonly known as double deckers. The move is also a new strategy in Japan, as structured products linked to bespoke Credit Suisse Headquarters, Zurich indices are usually marketed and sold to retail investors, exemptions for the current uncleared OTC swaps market and exchange- according to market watchers. (continued on page 2) (continued on page 12) COPYRIGHT NOTICE: All materials contained in this publication are protected by United States copyright law and may not be reproduced, distributed, transmitted, displayed, published, broadcast, photocopied or duplicated in any way without the prior written consent of Institutional Investor. Copying or distributing this publication is in violation of the Federal Copyright Act (17 USC 101 et seq). Infringing Institutional Investor s copyright in this publication may result in criminal penalties as well as civil liability for substantial money damages. ISSN# Unauthorized reproduction, uploading or electronic distribution of this issue, or any part of its content is illegal without the Publisher s written permission. Contact us at (800)
2 At Press Time Investors Bullish On Morgan Stanley Exchange-traded calls are being bought and puts sold on Morgan Stanley stock, despite rumors the firm might receive a credit rating cut in mid-june from Moody s Investors Service. On Tuesday, investors bought over 25,000 contracts of June calls with strikes at 18, while on Monday investors bought 15,000 of the same contracts. Last week, investors purchased 25,000 June calls with strikes at 19 and 10,000 delta-neutral June calls at 20 strikes. In late April, an investor sold 10,000 Oct. puts with strikes at 16. MS stock was at at press time. All June contracts expire on the 16 th of the month. Chris Jacobson, derivative strategist at Susquehanna International Group in New York, told DI that the size and consistency of the trading for Morgan Stanley options was notable. Put sales can be of even more interest than call purchases, as they entail a significant amount of downside risk and thus can give us a sense of investor comfort at certain levels, he added in a strategy note this morning. SIG is a financial trading firm. The flow likely means that some investors feel the risk of a downgrade cut has been priced into the market, meaning they feel better-than-expected news or even just expected news could lead to a gap higher in the stock come June, Jacobson noted. He added that skew on the stock, or the measure of the prices between similar out-of-the-money puts and calls, has shifted away from puts towards calls, indicating that the risk for a gap move in either direction is more balanced, despite the stock moving lower and the rumor of a downgrade. There is no set date for an update on MS from Moody s but the expectation is for some time in mid-june. Early last week, MS published estimates for the amount of collateral it would need to post in the event of a two- or three-notch downgrade. Those estimates landed at USD6.8 billion and USD9.6 billion, respectively. Susquehanna analyst Doug Sipkin, who covers the stock, noted these numbers are up from USD5.2 billion and USD6.5 billion at the end of MS noted that the ratings could have an impact on longer-term OTC derivative trading revenues, he added. Despite the estimates, Sipkin also remained bullish. We believe shares are attractive while we can appreciate the uncertainty created by future credit rating moves, he wrote in a note. Labor Dept. (Continued from page 1) traded futures market, but has not provided guidance whether those exemptions will extend to the cleared market. Lyssa Hall, director of the Office of Exemption Determinations, did not respond to an request for comment on the DoL s timeframe by press time. It s clear the Department of Labor has a grasp on what s going on and is working hard, but as the timeframe becomes tighter and tighter, the investment industry is starting to understand that this has the potential to be a major roadblock on the path to implementing over-the-counter clearing for its clients, said Joanne Medero, managing director in the Government Relations Group at BlackRock in San Francisco, Calif. Under DoL s byzantine process, the Office of Regulatory Interpretation will decide first if the exemptions will extend to the cleared market. If not, then The Office of Exemption Determinations would decide whether an additional exemption should be put in place. A member of the Exemption Division told DI it has received an application for an exemption and it is under consideration currently, but declined further comment. It is doubtful swap dealers would enter into a cleared swap with a pension plan without further guidance, said Bronislaw Grala, a senior counsel at Cadwalader, Wickersham & Taft. We re working to bring the agency up to speed, but it s a complicated issue and there is concern that the process could take an extended period of time. The matter is complex because uncleared swaps and futures receive different exemptions in different cases, and the DoL needs to understand the whole market before making a decision. But despite its rap for being deliberate, in the financial crisis of 2008 the agency acted quickly in providing relief for pension plans. Mike Kentz Derivatives Intelligence EDITORIAL Steve Murray Editor Tom Lamont General Editor Peter Thompson Executive Editor [Chicago] (773) Robert McGlinchey Managing Editor [London] (44-20) Daniel O Leary Senior Reporter & Hong Kong Bureau Chief (852) Mike Kentz Senior Reporter [New York] (212) Kevin Dugan Reporter [New York] (212) Beth Shah Associate Reporter [London] (44-20) Venilia Batista Amorim London Bureau Chief (44-20) Stanley Wilson Washington Bureau Chief (202) Kieron Black Sketch Artist PRODUCTION Dany Peña Director Deborah Zaken Manager Melissa Figueroa, James Bambara, Douglas Lee Associates Jenny Lo Web Production & Design Director ADVERTISING Patricia Bertucci Associate Publisher (212) Adrienne Bills Associate Publisher (212) PUBLISHING Allison Adams Group Publisher Gauri Goyal Business Director (212) Anna Lee Marketing Director (212) Laura Pagliaro Senior Marketing Manager (212) Vincent Yesenosky Head Of US Fulfillment (212) Nina Bonny Customer Service Manager (212) SUBSCRIPTIONS/ ELECTRONIC LICENSES One Year $4,595 (In Canada Add $30 Postage, Others Outside U.S. Add $75) Ken Lerner Account Executive (212) Kellyann Flynn Account Executive [London] (44-20) REPRINTS Dewey Palmieri Reprint & Permission Manager [New York] (212) investor.com CORPORATE Jane Wilkinson Chief Executive Officer Steve Kurtz Chief Operating Officer Customer Service PO Box 4009, Chesterfield, MO , USA Tel: Fax: UK: Hong Kong: Institutional Investor Hotline (212) and (1-800) or Editorial Offices 225 Park Avenue South, New York, NY Derivatives week is a general circulation newsweekly. No statement in this issue is to be construed as a recommendation to buy or sell securities or to provide investment advice. Derivatives Week 2012 Institutional Investor, LLC Issn# Copying prohibited without the permission of the publisher. 2 Institutional Investor, LLC 2012 VOL. XXI, NO. 19 / May 14, 2012
4 SocGen Touts Energy Compression Play Société Générale is advocating compression plays by buying credit default swaps on Canadian Natural Resources (CNQ) against Anadarko Petroleum, Nexen Inc., Talisman Energy, Hess Corp. and Marathon Oil Company. According to a report, Jaimin Patel, strategist for SocGen, said that CDS spreads on CNQ are basis points too tight relative to its peers. He later told DI that those companies were selected because they were triple-b companies with relative historical spreads as opposed to higher-rated companies like Apache Corp. and Occidental Petroleum Corp. Patel said that CDS on CNQ could widen because about 50% of CNQ s total revenues are tied to Western Canadian Select, which produces heavy crude and thermal oil. Patel s report notes that WCS prices increased to USD per barrel in the first quarter of 2012 from USD94.02 in Q4 2011, but that prices have evened out since maintenance at refineries has been completed. It seems to be resolved for the moment, he said. As of May 4, according to Markit, CDS spreads on CNQ were 122 bps, Anadarko 152 bps, Nexen 171 bps, Talisman 158 bps, Hess 148 bps and Marathon 110 bps. BNP Sees China/Brazil vs. U.S. Equity Decorrelation U.S. equities are poised to decorrelate from Chinese and Brazilian equities, say strategists at BNP Paribas, and investors can capitalize by buying calls on individual indices and selling calls on a basket of all three. The S&P 500, Hang Seng China Enterprises Index, and the ishares MSCI Brazil exchange-traded fund all posted strong gains through mid-march this year but declines in the Chinese and Brazilian indices of 7% and 15%, respectively, since then have sparked an initial decline in correlation levels with respect to U.S. equities. BNP strategists believe this trend may continue. They told DI the firm s traders have noted some selling pressure on correlation among the indices in the inter-dealer broker market, indicating the phenomenon of declining correlation may have already started. The pitch is to buy out-of-the-money calls on each individual index maturing in Dec. 2013, for example, while selling quanto U.S. dollar out-of-the-money calls on a basket of all three indices maturing at the same time for what would have priced out at 1.10% at the end of last week. Quanto U.S. dollar calls pay out in dollars. Deutsche Touts MXN/RUB Structure Deutsche Bank is advising investors to sell three-month at-themoney forward U.S. dollar/russian ruble puts versus buying 3-month 1% out-of-the-money forward USD/Mexican peso puts. Instead of trading outright MXN/RUB cross, we favor option implementation since it protects us from further slide in MXN/ RUB by giving up profit from an unlikely scenario, Jack Zhang, emerging markets strategist in New York, told DI. MXN was undervalued based on our valuation model while RUB was more in line, added Zhang, referring to when the trade was first recommended April 23. The trade has become more favorable following the unexpected decision not to cut interest rates by Banco de México. There had been expectations of cuts given the very dovish stance coming from Banxico Governor [Agustin] Carstens, said Sebastien Galy, currency strategist at Société Générale, in New York. Spot wise, the USD/MXN range may now move lower if the risk environment continues to be positive, said Galy. The conditional structure presents a self-hedging property, which for this trade means that it hedges a possible loss scenario by giving up profit in an unlikely scenario, according to Zhang. Additionally the RUB is an MXN/RUB cross (2Y History) attractive means of funding. I think it s quite an interesting trade, although I think USD/RUB vols look a bit pricy for what they are. I wouldn t be that keen on the idea of RUB appreciation because I think oil prices are vulnerable at the moment still, Simon Smollett, fx options strategist at Crédit Agricole Corporate and Investment Bank, in London, told DI. Oil price rising helps both countries, but if oil is waning, then RUB is in real trouble, he added. Source: Deutsche Bank Spot on USD/RUB sat at RUB by press-time with 3-month implied volatility at 10.55%. Spot on USD/MXN sat at MXN with 3-month implied vol on the pair at 12.90%. 4 Institutional Investor, LLC 2012 VOL. XXI, NO. 19 / May 14, 2012
5 Firm Legal Teams Gear Up For Swap Dealer Regime Firm compliance teams are swinging into action to prepare for potential registration as swap dealers or at least to figure out, along with the business side, whether they will avoid having to enroll. Their efforts have come into sharper focus now that the Securities and Exchange Commission and the Commodity Futures Trading Commission have finally adopted rules defining swap dealers. Those firms that meet the criteria in the recently adopted rules will have to sign up with both agencies within 60 days of the publication of a final rule that spells out definitions of financial products such as swap, security-based swap and securitybased swap agreement known as the products rule. The precise definitions the SEC and CFTC use in the products rule will help determine which firms are classified as swap dealers. Industry watchers expect that to be finalized in the fall. But in the meantime, many professionals regard the products rule proposal and the swap dealer definition as offering a sufficiently detailed roadmap to start compliance work, even if gaps remain. The CFTC has also recently finalized rules governing business conduct and recordkeeping for swap dealers. You can start putting in place a compliance infrastructure, Gary DeWaal, group general counsel with Newedge, told DI sister publication Compliance Intelligence. Right now our compliance officers are putting Gary DeWaal together detailed lists of what will have to be done [if some or any of our entities have to register]. There are a lot of blanks or entries marked proposed...but it s a very complex to-do list. DeWaal estimated that firms will each have to spend millions to tens of millions of dollars to comply with swap dealer registration requirements. The business conduct and recordkeeping rules create a vast array of compliance challenges, but professionals say certain issues stand out and that firms are already working on them. Key to successful preparation will be setting up work streams that can handle the various testing exercises that are needed simultaneously, said Ross Pazzol, a partner at Katten Muchin Rosenman, adding that it will take too long to do these one at a time. One challenge is the need to separate risk management from business units. Firms must analyze who will sit in the swap dealing business and who will be in risk, Pazzol said. Among other things, chief compliance officers need to figure out if their firm has an affiliated futures commission merchant that does research, as this might present a conflict of interest and mean their firm cannot talk to the FCM except for the rare occasion when it is helping the affiliate manage a default. Under looming capital rules, stand-alone brokerages will have to comply with complex formulations, while combined FCM/swap dealers will be able to take advantage of a simpler regime. This presents a dilemma for certain firms, Pazzol said. One of his client firms has said it plans to register as a swap dealer with the attendant additional compliance requirements because it doesn t believe the complex capital rule would suit it. Peter Malyshev, counsel with Latham & Watkins, said he is already on frequent conference calls with clients working on swap dealer registration-related issues. Firms have the opportunity at this stage to tweak their businesses by reducing their exposure to qualifying swaps if it looks like they ll have to register and don t wish to, he said. Those that do go down the road to enrollment need to focus on whether their business conduct standards are up to scratch. The firms widely regarded as those most likely to be defined as swap dealers were less inclined or able to talk. Officials with JPMorgan Securities, Bank of America, Citibank, Goldman Sachs and HSBC either did not respond to requests for comment or were not made available by press time. Eurozone Fears Trigger EUR/USD Put Barriers Knock-out puts on the euro against the U.S. dollar have been triggered in recent days following a sharp decline in the euro. The drop in spot comes as concerns increase over Greece and its political instability, on top of the fiscal state of other eurozone members. The options had knock-out levels at USD According to traders, anyone short EUR/USD and long volatility would have made money, and anyone who bought reverse knock-out options knocked out would have lost money. The types of investors on either side of the trades could not be gleaned. EUR/USD fell to a three-month low during afternoon trading Wednesday hitting USD The euro is on the brink of a record losing streak, but the market mood of inevitable demise is reminiscent of the same misplaced bearishness on JPY earlier this year, said David Bloom, global head of fx strategy, at HSBC in London, in a report. EUR/USD since the start of the year has been holding above I suspect those buying barrier options avoid big figures such as for their out strikes. Hence, may have been popular, Simon Smollett, fx options strategist at Crédit Agricole Corporate and Investment Bank Simon Smollet in London, told DI. It means that another raft of EUR bulls have been taken out of the market, but not sure it is bearish for EUR/USD, but it probably accounted for the sharp spot sell-off yesterday, he added. Spot on EUR/USD sat at USD earlyon Wednesday. Threemonth implied volatility was 10.90%. VOL. XXI, NO. 19 / May 14, 2012 To sign up for alerts and online access, call or
6 Asia Pacific India Tax Rules To Take Hard-line On OTC Trades New anti-tax avoidance rules in India could snare foreign investors and dealers active in the country s over-the-counter and offshore equity derivatives market. The General Anti-Avoidance Rules found in the Finance Bill 2012 are designed to close loopholes in India s tax code. The rules will make it harder to structure financial transactions in order to avoid tax and will also make it difficult for transactions executed offshore by foreign institutional investors to escape taxation. GAAR s indirect transfer tax provision, which recognizes the transfer of foreign assets as an Indian asset if it derives its value substantially from assets located in India, is causing the most concern among foreign institutional investors, according to market watchers. Hoshedar Wadia, partner at law firm Juris Corp Advocates & Solicitors in Mumbai, said GAAR will enable tax authorities to collect tax from deals executed offshore by foreign firms. GAAR will be used to find out who the final beneficiaries of the transaction are and effectively tax those entities for the gains those entities will get out of it, Wadia said. Wadia said many of India s participatory notes--instruments that derive their value via Indian securities and purchased by non- Securities & Exchange Board of India approved foreign investors are executed through Mauritius. The thought is that GAAR will be used to go behind the transaction and tax gains on such investments in Indian equities by ignoring the fact the investment was made through Mauritius and actually go after the entities in the jurisdiction they were incorporated in, he noted. Wadia said the market is also concerned that the GAAR in its current form is too unrestricted. Authorities could pretty much do what they like when they like and that is certainly something that causes concern, he said. GAAR will also force investors and firms to show questionable transactions have not been structured for the purpose of tax avoidance, effectively putting the burden of proof on the accused. The Finance Bill 2012 was scheduled last Monday for further debate in India s national parliament. SocGen Preps Equity-Linked Structures In HK Société Générale plans to launch four equity-linked structured products in Hong Kong. The structures, which can use so-called airbag features, will be linked to single stocks. SocGen offered a similar range of structured products in April, which referenced a basket of stocks (DI, 26/3). These are the second series of structured products this year since a new reporting and disclosure regime took effect in Hong Kong in early 2011 (DI, 5/9). According to a prospectus lodged with the Hong Kong Securities and Futures Commission, the so-called Callable Single Equity-Linked Investment Contracts with Potential Cash Distribution notes will offer different ranges of daily and periodic calls and may include at-expiry or daily airbag features. Callable structures allow the issuer to close out the investment if a predetermined barrier is hit on the underlying, while the airbag feature offers unlimited upside participation with conditional downside protection. Both the Royal Bank of Scotland (DI, 7/6) and Heng Seng Bank (DI, 08/08) have used airbag features in Hong Kong structured products within the last 12 months. The tenors of the structures range from three months to three years, according to the prospectus. The launch date of the structures could not be gleaned. Spokespeople at SocGen declined to comment. Investors Tap AUD/USD Risk Reversals Institutional investors are still going long the Australian dollar despite the sudden slide of the currency this week, buying threemonth out-the-money AUD/USD risk reversals. Appetite for put spreads on the pair has also increased. The risk reversals are favoring Aussie puts quite aggressively, said a senior Hong Kong fx trader. Strikes that are popular are around three-month 98 and 95. There has been a correction lower in the three-month 25 delta risk reversals, but still way above the ACCESS MONDAY S ISSUE ON FRIDAY Access the most recent issue of Derivatives Week as a PDF the Friday before it s available in print. Log onto and click on Download Current Issue PDF at the top of the page. To obtain access please contact the subscription hotline at 1 (800) / 1 (212) or
7 September-December levels last year. Spot in the AUD fell another 0.01% Tuesday afternoon in Asia to after it depreciated to Monday, its lowest level all year, according to traders. The Royal Bank of Australia s 50 basis point cut to interest rates two weeks ago to 3.75% and last week s trade deficit data from the Australian Bureau of Statistics, which showed imports outgrew exports by AUD1.587 billion (USD1.609), also weighed heavy on AUD appreciation expectations. The trader said investors are also looking at three-month AUD/ USD put spreads with a target of Investors are waiting for slightly better levels before executing the trades, he noted. I definitely think there s more downside in the Aussie. You could use the area as a pivot point. For fresh [alternatives] I would still be looking for moves towards 98.5 within three months. Volatility on Australian dollar risk reversal options, however, has been pricing slightly lower appreciation against the U.S. dollar and other regional crosses, he said. Volatility on AUD/USD options was 4.2 vols at the time of publication, down from yearly highs of 6 vols, according to traders. Japan Sets Out Mandatory Clearing Rules Japan is set to become the first country to implement mandatory clearing of over-the-counter credit default swaps and interest rate swaps. The Financial Services Agency will implement the first phase of the reforms from November, according to a draft of its detailed rules and cabinet office ordinance. The Japanese language document s scope limits clearing to yen-denominated transactions booked onshore that are made between Japanese legal entities. Cross-border and offshore deals between foreign banks will not be subject to the regulations, according to the rules. International trade repositories can also be used to report Japanese trades. One exemption in the rules, according to a Tokyo lawyer, means only trades already cleared via the Japanese Securities Clearing Corp. had to be mandatorily cleared. I think the regulators are expecting interest rate swaps will be cleared by October, he noted. That sort of limits it. And the class of swaps was already limited. A senior market official in Tokyo said client clearing also presents a challenge for the market. Client transactions are not subject to the regulations in phase one, but the Japanese FSA is trying to mandate onshore clearing for client transactions in phase two, the official said. The FSA is trying to start client clearing next year, so this will be the next main topic up for discussion. The official added that risk management of the clearing broker and the collateral standards posted to the clearing house needs clarification. The client or the broker will be required to post a huge amount of collateral to the CCP, the official noted. The type of collateral is also limited to cash. Some firms might have funding problems. A spokesperson at the FSA did not return calls. People & Firms DB Bigwig Departs Christian Bittar, managing director and head of money market derivatives at Deutsche Bank in Singapore has left the firm. It is understood he is moving to global hedge fund BlueCrest Capital Management, although details of his responsibilities could not be gleaned. The departure follows other Deutsche Bank officials moving to BlueCrest, including credit trader Stefano Galiani, according to media reports. Further details on that move could not be gleaned by press time. Bittar and spokespeople at BlueCrest and Deutsche Bank did not return calls. CS Fx Trader Moves To Citi Ayad Butt, an ex-g10 fx derivative trader at Credit Suisse in Singapore, is set to join Citigroup in a similar role. Butt left Credit Suisse in April (DI, 5/12). He had been with the firm for five years, starting as an analyst in New York. In Singapore, he reported to Tom McNee, head of developed markets fx options trading for Asia at CS. Butt could not be reached. A Citi spokesperson did not immediately return calls by press time. News Clippings News clippings includes stories from other news sources from around the market. DW does not guarantee the completeness or accuracy of the stories gleaned from other sources, though they are believed to be reliable. Over-the-counter derivatives volumes declined 10% in the second half of 2011 to USD trillion, according to the Bank for International Settlements. (Bank for International Settlements, 5/9) NYSE Arca Options and the International Securities Exchange are seeking permission from the U.S. Securities and Exchange Commission for smaller equity derivatives trades namely, those based on 10 shares for at least five stocks. (Bloomberg, 5/9) Credit default swaps on Spain s sovereign debt widened 18.5 basis points to a record bps on concerns that a bail out of Bankia, the country s third-largest lender, would not avoid a banking crisis spurred by toxic real estate loans. (Bloomberg, 5/9) Moody s Investors Service said Wells Fargo Securities acquisition of prime brokerage Merlin Securities as part of an expansion into capital markets is credit negative. (Securities Lending Times, 5/9) VOL. XXI, NO. 19 / May 14, 2012 To sign up for alerts and online access, call or
8 Learning Curve E.U. Technical Proposals On UCITS ETFs The European Securities and Markets Authority published a consultation paper Jan. 31setting out its proposed guidelines on UCITS exchange-traded funds and other UCITS-related issues. The consultation period ended March 31, and ESMA will finalize the guidelines for adoption this quarter. ESMA s proposals concern both synthetic and physical UCITS ETFs, and include suggested rules for index-tracking UCITS, efficient portfolio management techniques, total return swaps and strategy indices. The scope of the proposed guidelines covers UCITS ETFs as well as all UCITS that engage in securities lending or whose investment policy tracks an index. The consultation paper sets out the following proposals: Index-Tracking UCITS The prospectus of an index-tracking UCITS should include: A clear description of the index, including its underlying components. This can be provided by a link to a website publishing the exact composition of the index; Information on how the index will be tracked (full replication or whether a sample or other method will be used), and how this affects the exposure of the investor to underlying index and counterparty risk; Factors likely to affect the ability of the UCITS to track performance (such as transaction costs, small illiquid components, divided reinvestments etc) and the policy regarding the ex-ante tracking error. The ex-ante tracking error is the discrepancy between the value of the UCITS portfolio and the actual return of the index. Annual and half-yearly reports should state the size of the tracking error for that period. The annual report should explain any divergence between the target and actual tracking error. Index-Tracking Leveraged UCITS The prospectus of an index-tracking leveraged UCITS should include: Disclosure of the leverage policy and how it is achieved, the cost of leverage and any associated risk; Disclosure of the impact of any reverse leverage (this should also be included in the KIID); A description of how the frequency of calculating the leverage impacts on investors returns in the medium to long term. Index-tracked leveraged UCITS should not be used to circumvent, and must comply with, limits on global exposure. Definition Of UCITS ETFs & Identifier ESMA proposes that a UCITS exchange-traded fund be defined as a UCITS at least one unit or share class of which is continuously tradable on at least one regulated market or multilateral trading facility with at least one market maker which takes action to ensure that the stock exchange value of its units or shares does not significantly vary from their net asset value. This is broadly similar to the MiFID definition and ESMA may consider further alignment between the two. UCITS that fall under the above definition should use the identifier ETF in their name, fund rules or instrument of incorporation, prospectus, Key Investor Information Document and marketing communication. UCITS not falling under the above definition should not use ETF in the aforementioned publications. Actively Managed UCITS ETFs There must be clear information in the prospectus, KIID and marketing communications that the UCITS ETF is actively managed and not an index tracker. This must include how it will meet its investment policy, its policy regarding portfolio transparency and information on where its indicative net asset value, if applicable, is published. The prospectus must disclose how the inav is calculated and the frequency of this calculation. Secondary Market Investors Market makers buy and sell shares, known as creation units, directly from the UCITS which they then split and sell on a secondary market. Only the market makers can redeem from the UCITS ETF. Proposal Option One A UCITS ETF or its management company should ensure the market maker continues to offer redemption to secondary market investors whilst the market remains open. If the market maker is no longer able or willing to act, appropriate action must be taken to replace the market maker whilst ensuring investors are protected, which may include arrangements allowing investors to sell directly back to the UCITS ETF. The prospectus should explain ETF units are generally not redeemable from the fund. The prospectus and marketing communications should also include the following statement: UCITS ETF units/shares cannot usually be sold directly back to the fund. Investors must buy and sell units/ shares on a secondary market with the assistance of an intermediary (e.g. a stockbroker) and may incur fees for doing so. Investors may pay more than the current net asset value when buying units/shares and may receive less than the current net asset value when selling them. Proposal Option Two Investors shall be able to redeem their shares directly from the UCITS ETF at any time, and the UCITS prospectus and KIID should state the redemption fee that will apply. 8 Institutional Investor, LLC 2012 VOL. XXI, NO. 19 / May 14, 2012
9 Efficient Portfolio Management Techniques The main efficient portfolio management techniques addressed are securities lending and repo and reverse repo. The proposals seek to make these techniques more transparent to the investors and impose requirements on any collateral received. The prospectus should contain information on: Techniques and instruments relating to transferable securities and money market instruments; The UCITS collateral policy; Fees arising from EPM techniques, disclosing any related feesharing arrangements; A disclosure if the third party is an investment manager or a connected party. A UCITS ETF must be able to recall any security lent or terminate any securities lending agreement at any time. Collateral received should comply with the relevant CESR Guidelines, and any collateral posted by a third party should be sufficiently diversified. UCITS diversification rules should be generally complied with. Entities receiving collateral should have their registered office in an EU Member State or be subject to the prudential rules of the competent authority in the EU Member State the UCITS is registered in. There must be a documented haircut policy for each class of asset received. The annual report should contain details of the underlying exposure from EPM techniques, the identity of the counterparties to these EPM techniques and the type and amount of collateral received by UCITS to reduce counterparty exposure. Total Return Swaps Some UCITS are using total return swaps to provide investors with a predefined payout. The underlying assets can be a variety of assets, strategies and indices, and are normally passively managed by the counterparty. UCITS diversification rules must be complied with in regard to: For unfunded swaps, the UCITS investment portfolio, the return of which is swapped, the underlying to the swap and any collateral posted to the swap counterparty. If the counterparty risk will be mitigated by posting collateral rather than resetting the swaps on a regular basis the collateral should be sufficiently diversified; For funded swaps, the collateral posted by the swap counterparty. Entities receiving collateral should have their registered office in an EU Member State or be subject to the prudential rules of the competent authority in the EU Member State the UCITS is registered in. The prospectus should provide investors with information on: The underlying strategy and composition of the investment portfolio or index, counterparties, and, where relevant, the type and level of collateral required and reinvestment policy (including the risks arising from it); The risk of counterparty default and the effect on investor returns; If the swap counterparty has discretion over the investment policy or their approval is required for any portfolio transaction, the extent of their control; If the swap counterparty has discretion over the composition or management of the portfolio, the agreement between them and the UCITS is treated as an investment management delegation arrangement and should comply with UCITS requirements and the counterparty disclosed as an investment manager. While the UCITS diversification rules should be expected to apply to a UCITS itself, the suggestion that they should apply to the underlying of a swap entered into by the UCITS appears arbitrary. Further, whilst disclosure on the quality of collateral is to be welcomed, it would be burdensome to disclose the exact instruments comprising the collateral in the prospectus as these are likely to differ depending on market variables. ESMA s paper does not draw a distinction between the investment strategy and the instruments used to gain exposure to this strategy, and this could be clarified. There is also widespread disagreement in the industry with ESMA s statement that TRS are normally passively managed, as it is the investment manager of the UCITS who decides whether to buy the TRS and on what terms it will pay out. The requirement for swap counterparties to be disclosed as investment managers is also seen by some as unnecessary, and may not even be possible to implement (or may only be possible to implement at significant additional cost to investors) if the counterparty does not have the appropriate regulatory permissions to act as investment manager. Strategy Indices A strategy index is an index seeking to replicate a quantitative strategy or trading strategy, and is normally operated by the index provider rather than the UCITS. Where relevant, the prospectus must inform investors of the intention to make use of increased diversification limits and why this is justified. A single component of an index, including different commodities with a commodity index, should not exceed the relevant diversification requirements. Strategy indexes must satisfy the index criteria by having a clear single objective (to represent an adequate benchmark for the market), and the universe and basis of selection of components must be clear to investors and competent authorities. The prospectus should disclose the rebalancing frequency and its cost within the strategy. Indices which rebalance on an intra-day or daily basis will not be sufficient as they do not satisfy the requirement that the frequency should not prevent investors replicating the financial index. Information on index constituents, index calculation, rebalancing methodologies, index changes and information on operational difficulties in providing information should be easily accessible (e.g. via the internet) to enable investors to replicate the strategy. The constituents of the index and their weightings must be published after each rebalancing, their selection must be pre-determined by objective criteria, there must be no backfilling of values, there must be documented due diligence on the quality of VOL. XXI, NO. 19 / May 14, 2012 To sign up for alerts and online access, call or
10 the index and there must be an independent valuation of the index (including when valuing any swap). Industry participants have indicated that disclosures should aim at allowing investors to replicate the calculation of the performance of the index rather than physically replicate the index. It has also been pointed out that in-depth disclosures are likely to be of limited use to the vast majority of investors, who will not have sufficient expertise and knowledge to understand the detailed methodology. Further, the requirement that strategy indices should be able to represent a benchmark is debatable as the index needs to be flexible. With regard to the statement that a daily rebalancing frequency will not satisfy the UCITS requirements for replication and transparency, some in the industry argue that daily and intra-daily frequency should be permitted as limitations on the application of such frequencies could lead to decreased performance in the index and increased cost for investors. Conclusion While improvements in transparency for investors in UCITS are generally to be welcomed, ESMA will need to tread carefully to ensure that any guidelines it adopts are proportionate and consistent with other regulatory reform initiatives. Various market participants have pointed out that it is inappropriate to view UCITS ETFs and structured UCITS in isolation from other instruments that are subject to MiFID, and that rules governing their marketing and product disclosure should be considered in connection with the current MiFID review. Given that UCITS are already subject to comprehensive regulation in respect of their product structure and disclosure to investors, there is a strong argument that no UCITS should be classified as complex under MiFID. Industry views are currently divided on this point, with some firms describing the splitting of UCITS into complex and non-complex categories as confusing to investors and potentially damaging to the UCITS brand, and other firms supporting this distinction and favoring the inclusion of complex UCITS within the scope of the Alternative Investment Fund Managers Directive. As the development of new rules for complex products under MiFID is still ongoing, it is perhaps unsurprising that ESMA did not address the distinction between complex and non-complex UCITS in its consultation paper. ESMA s final guidelines are expected to be adopted this quarter. UCITS managers will need to ensure relevant fund documentation (e.g. the rules or instrument of incorporation of the UCITS, its prospectus, its KIID, and any marketing communication) complies with the guidelines within one year of the adoption of the guidelines, or at such earlier date following adoption of the guidelines on which the documentation in question is issued or renewed. This week s Learning Curve was written by Ash Saluja, partner at CMS Cameron McKenna in London. Nominate Your RISING STAR of Derivatives! Derivatives Intelligence/Derivatives Week is taking nominations for our Publisher Awards for the 2012 Rising Stars of Derivatives. Have your say in recognizing the up-and-coming traders, salespeople, analysts, buyers, legal advisors, and clearing and operations specialists who are making a significant impact on your desk, business, customer base, or practice. The Publisher of Derivatives Intelligence will review all submitted names and their achievements to select the 2012 Rising Stars. On Wednesday, September 19, 2012, they will also receive awards at the 2012 Global Derivatives Awards annual gala dinner at The Four Seasons Hotel London at Park Lane. Please send nominations by July 25 to Submissions should have the nominee s name in the subject line and include their contact details as well as a brief summary on how they meet the following criteria (attaching supporting documentation is optional): For information on sponsoring or attending the 2012 Global Derivatives Awards, please contact: Patricia Bertucci, Associate Publisher, ; Demonstrated expertise and recognition in OTC derivatives Worked on some of the market s biggest deals Helped sell or structure the most innovative deals Contributed to the desk s superior performance in difficult market conditions Won accolades on the buy-side for expertise or innovation Helped expand into new markets. Initiated new developments in operations and clearing that had a significant bottom-line impact.
11 Sovereign Credit Markets Greece Is Back By Gavan Nolan, credit analyst, Markit All the talk in the markets in the run-up to last Sunday s elections was that the French vote would be pivotal for risk appetite and it is not hard to see why. The formation of a working relationship between newly-elected Francois Hollande and Angela Merkel will be crucial for the future of the eurozone. That will emerge Gavan Nolan over the coming weeks and months, and headlines generated by both leaders will have a strong influence on spread direction. But it was the election in Greece that triggered a considerable bout of volatility this week. As expected, it was a disaster for the two establishment parties PASOK and New Democracy. The latter gained the most seats but nowhere near enough for a majority. It tried and failed to form a government, and the mantle then passed to leftist group Syriza to try and form a coalition. They also failed, but not before scaring the markets with their anticapitalist rhetoric. Syriza s leader declared the conditions of the bailout as barbaric and declared the deal invalid. He has also questioned the legality of the country s debt. At press time, the most probable scenario seems another election in June, where the latest polls indicate that Syriza would make further gains and emerge as the largest party. This would not be a marketfriendly outcome. Syriza seems to be gambling that it can use its eurozone membership as a bargaining chip to tear up the bailout agreement. It is clearly a risky strategy there are undoubtedly figures in the German government that would prefer to cast Greece adrift. But there are also important forces that are fearful of contagion in the event of Greece defaulting on official debt and leaving the euro. A unity government is another possibility, which would be preferable to the markets but would also be perilously fragile. Sovereign spreads widened both in the core of the eurozone and its periphery. Spain s 5-year credit default swaps touched a new record of 520 basis points on Wednesday as the threat of contagion from Greece loomed. However, Spain also had its own problems to deal with. The government part-nationalised Bankia, a struggling lender formed by merging seven cajas, and laid out plans to force banks to set aside larger provisions against property loans. Greece s political instability and the evolution of the Franco- German relationship will continue to drive sentiment but the region s banks are still a burden on sovereign credit. Unique Fixed (Continued from page 1) offering launched last month. Fixed indexed annuities, like a fixed annuity, provide a guaranteed rate of interest determined at the outset by the insurance company. But, like a variable annuity, they provide market-linked exposure by way of several sub-account choices. Variable annuities provide choices of sub-accounts, usually mutual funds, and the investment can move back and forth between funds without creating taxable events. Fixed indexed annuities stay in one bucket through maturity, thus they are less risky than variables because they provide a guaranteed rate but more rewarding than a straight fixed because they are market-linked. The TVI index, on which the RBS index is based, provides exposure to 24 U.S. exchange-traded futures contracts across physical commodities, global currencies and U.S. interest rates on a notional basis. RBS added the volatility control mechanism to create ALTVI, which comes with additional fees to SBL of 1.25%. RBS increases exposure to the TVI index when realized volatility is on the lower end of a range determined by the firm and decreases exposures when realized vol approaches the maximum. The ALTVI exposure to TVI can range from 10 to 150%. ALTVI is annuity linked because the volatility control mechanism ensures a guaranteed rate of return. Roger Offermann, senior v.p. and chief actuary for SBL said the firm buys mostly at-the-money options on the index on a weekly basis, all maturing in five years, but will buy slightly in- or out-of- the-money options when necessary to hedge whatever it has sold to its clients. Investors submitted approximately USD40 million in premium the first month, and Wolff added the firm has just received regulatory approval to market in 15 more states, bringing the total to 44, and expects [the number] to go up quite a bit. The firm is bringing in USD million a month in both of its fixed index annuity investments. Wolff believes the USD30-35 billion a year marketplace in the U.S.is growing rapidly. SBL currently has an exclusive license to trade options on the index with RBS and Wolff admitted there are certain pluses and minuses to that arrangement. The more liquidity that s available, the less expensive the options would be to purchase, he said. But the positive is that the exclusivity we think gives our distribution partners an edge in the field. SBL operates through wholesalers, not financial planners. Variable annuity investments have become increasingly difficult for insurance companies to hedge over the last year due to high variance swap prices (DI, 3/15). Wolff said low interest rates are the main reason. Mike Kentz VOL. XXI, NO. 19 / May 14, 2012 To sign up for alerts and online access, call or
12 CS To Go (Continued from page 1) The firm is looking to issue the products now as Japanese institutional investors have increasingly been looking to take exposure to emerging market equity and currencies in a bid to increase yields. One Tokyo-based official said investors are looking for more transparent and vanilla structured products due to Japan s Financial Services Agency clampdown in February, which was aimed at stemming the sudden popularity of the risky double decker structured products. They want it to be very transparent, with high liquidity, the official noted. Credit Suisse is looking at a combination of tracker certificates and funds on the funded side and swap-based structured products on the unfunded side. In terms of positions, it looks like an exchange-traded fund, with full liquidity and transparency, he noted. The official declined to elaborate further. The call for less risky structured products is being driven by the FSA s negative opinion of double deckers. They became popular among Japanese institutional investors last year, and caught the regulators attention when a number of investors incurred losses. The deals--typically used in Japan to take exposure to emerging markets-- take high-yielding assets, such as equity real estate investment trusts, and combine them with a high-yield currency fx derivative overlay. The Brazilian real has been the most popular emerging market currency underlying in the deals, according to market participants. The official said the index-linked structured products are a less risky alternative to double deckers. [Double deckers] are very profitable when they work, but when things go badly they drop dramatically, the official said. That s why local investment managers are looking for alternative fx overlays that are less risky and hope for more stable performance. Credit Suisse s EM index references 17 emerging market currencies and contains a combination of Asian, European and Latin American currencies. Using fx to take macro exposure to these countries can work far better in giving you exposure to this growth, the official said. So, [Credit Suisse] put together a fairly simple index that is long global emerging market currencies against the dollar. Getting institutional investors interested in index-linked structured products, an investment usually aimed at retail, highnet-worth individuals, means the products will look almost like a synthetic exchange-traded fund, he said. The interesting thing to see is whether this will fly or not with institution investors, he said. Daniel O Leary Quote Of The Week It s clear the Department of Labor has a grasp on what s going on and is working hard, but as the time frame becomes tighter and tighter, the investment industry is starting to understand that this has the potential to be a major roadblock on the path to implementing over-the-counter clearing for its clients. Joanne Medero, managing director in the Government Relations Group at BlackRock in San Francisco, on how the Department of Labor s rules could make it tough for swap dealers to clear over-thecounter swaps for pension funds (see story, page 1). Libor Plus JPMorgan s USD2 Billion CDS Folly JP Morgan has lost over USD2 billion since April 1 because of credit default swap positions taken by the firm s London chief investment office. And there s the potential that the firm can lose another USD1 billion or more if the markets refuse to cooperate with their position. Jamie Dimon, JPM president and ceo, said during a conference call that the positions were egregious and self-inflicted. But that was not the most troubling thing he said during the conference call. It could get worse, and it s going to go on for a little bit unfortunately. According to the Wall Street Journal, hedge funds BlueMountain Capital Management and BlueCrest Capital Management have made at least USD30 million taking an opposing position. One trader who talked to the Journal said that JPM s position was so large that it skewed the market and made an opposing position cheap. But other reports have said that fast money moved directly against JPM because its bets were, well, too big not to fail. JPM sold CDS on the ninth Markit CDS index of North American investment grade corporate, also called the CDX IG 9, which is an off-the-run index of 121 corporates. JPM sold insurance because, in its view, the spreads would widen. With the cost of the index risk higher, the firm would be able to turn around and repackage it, or at the very least see higher value on its books. But that didn t happen. According to Markit, the spread for the CDX IG 9 started this year at 129 basis points. As of May 9, the last day data is available, the spread is 77 bps. So the value of the risk is about half that of the beginning of the year, with potential losses still to come. Since the news broke, there has been chatter that this will strengthen the position of regulators looking to clamp down on the so-called Volcker rule, which bans proprietary trading (however they define it). This may be the Game-Changing nail in the coffin of the CDS market, wrote Bill Blain, senior director at NewEdge in his daily morning . CDS will be stripped, abused and crucified by vengeful legislators. CDS will end up neutered underlying position trading only. Dimon, during the conference call, maintained that the trades were legitimate portfolio hedging, which would not violate the Volcker rule should it have been in place. But that doesn t mean much to regulators. The enormous loss JPMorgan announced today is just the latest evidence that what banks call hedges are often risky bets that socalled too big to fail banks have no business making, U.S. Senator Carl Levin, a Michigan Democrat, said in a statement on Thursday. Kevin Dugan 12 Institutional Investor, LLC 2012 VOL. XXI, NO. 19 / May 14, 2012
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