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winter 2012

Global Interests

2 J.P. Morgan thought / Winter 2012

Thinking Out LoudThe current issue of Thought marks my first as the new CEO of

Worldwide Securities Services. I am excited by the opportunities

this business provides to continue building on past success

through innovative partnerships with our clients and other market

participants. I hope you find your engagement with WSS offers not

only an expertise within our core product set, but also a portal to the

broader knowledge and capabilities of our entire global firm.

This time of year prompts reflection on the past in union with

anticipation for the future. What we’ve seen industry-wide in the

past six months is continued volatility in the global markets and

the prospect of complex changes precipitated by new industry

regulations. For you, our clients, some of these changes have created

uncertainty; others may see opportunity on the horizon.

In this issue, “Global Interests,” we explore topics of significance on

a global scale that pertain to both change and opportunity. Inside

you’ll find a review of the challenges ahead for asset managers and

an overview of collateral diversification in securities lending. For a

regional perspective, we offer a look at pensions’ reform in Europe,

the resurgence of private equity in Asia and some key elements of

the Brazil market. With an eye on evolving regulations, we examine

the regulatory impact on OTC derivatives and also on global fund

distribution. Whether you are affected by change or thinking about

opportunity, J.P. Morgan can bring its extensive resources to assist

your needs.

Thank you for reading. Please know that your questions and

comments are always welcome and may be sent to

[email protected].

Dinkar Jetley Chief Executive Officer Worldwide Securities Services

Dinkar JetleyChief Executive

Officer, Worldwide

Securities Services

Whether you are affected

by change or thinking about

opportunity, J.P. Morgan can

bring its extensive resources to

assist your needs.

Winter 2012 / J.P. Morgan thought 3

winter 2012

J.P. MorganWorldwide Securities Services

tom ChristoffersonGlobal Sales and Client Executive+1 [email protected]

Chris LynchAmericasMarket Executive+1 [email protected]

Laurence BaileyAsia-PacificMarket Executive+852 [email protected]

Francis JacksonEMEAMarket Executive+44 [email protected]

4 16 3321 Pensions’ reform in europe

Are the available options sufficient for remedying perceived weaknesses in the European pensions’ system?

24 independent Collateral Agents: the interconnecting Link

The important role that collateral agents play in the crucial process for managing and mitigating credit risk.

26 A Best Practice Approach for Designing a Securities Lending Program

Building a solid securities lending program and the options available for program structure, loan types, parameters and collateral.

30 the Benefits of Collateral Diversification in a Securities Lending Program

A closer look at the fundamental role collateral diversification plays in the risk mitigation process for securities lending.

33 Golden Opportunities Optimizing assets to their best

advantage—new ways for putting gold to work to diversify the collateral pool.

36 From idea to implementation: U.S. tri-Party repo Market reforms

A self-directed, private-sector task force implemented fundamental reforms in 2011, creating a radically transformed market.

4 regulatory reform and Collateral Management

In the wake of the global financial crisis, the impact of new regulations on major participants in the OTC derivatives markets.

8 Countdown to the Foreign Account tax Compliance Act

Requirements and possible challenges for non-U.S. financial institutions as mandated by the U.S. with FATCA.

10 new Challenges Ahead will test Asset Managers

A comprehensive summary of some of the changes facing the European asset management industry today and going forward.

14 And How will the resulting regulations impact Global Fund Distribution?

The current UCITS fund distribution model faces the prospect of meeting the demands of new regulatory requirements.

16 the resurgence of Private equity in Asia

An examination of trends and opportunities for private equity investors looking to build diversified portfolios in Asia.

18 Accessing the Brazil Market Brazil illustrates how, in the long run, a

fully regulated environment can prove to be beneficial for the funds industry.

About J.P. Morgan

Worldwide Securities Services

J.P. Morgan Worldwide Securities

Services (WSS) is a premier securities

servicing provider that helps

institutional investors, alternative asset

managers, broker-dealers and equity

issuers optimize efficiency, mitigate

risk and enhance revenue. A division

of JPMorgan Chase & Co., WSS

leverages the firm’s unparalleled scale,

leading technology and deep industry

expertise to service investments

around the world. It has $16.3 trillion

in assets under custody and $7.3

trillion in assets under administration.

For more information, go to

jpmorgan.com/wss.


Regulatory Reform and Collateral Management: The Impact on Major Participants in the OTC Derivatives Markets


The new regulations that will take effect in the wake of the global financial crisis are expected to

have a particularly profound impact on the $560 trillion OTC derivatives market. A combination

of the Dodd-Frank Act, the European Markets Infrastructure Regulation (EMIR) and Basel III will

result in wholesale changes to how OTC derivatives are settled, collateralized and reported.

The amount of collateral held against OTC trades, and the operational complexity of moving and segregating margin, are both expected to increase sharply. Virtually all experts predict that costs will rise, and many expect a resulting drop in volumes.

The impact of these changes to the buy-side has received wide media attention given that mandatory clearing of swaps and initial margin are both new requirements that will affect pension funds, asset managers and other institutions trading derivatives. According to Mike Reece and Jason Paltrowitz, J.P. Morgan market executives for banks and broker-dealers for Europe and the Americas, respectively, the impact to banks, broker-dealers and clearinghouses has been less well covered. “These institutions cannot risk being caught off-guard by the systemic changes to trading and collateralizing OTC derivatives,” they note.

Highlights of the new regulationsIn April 2009 the G20 nations made a commitment to “promote the standardization and resilience of credit derivatives markets, in particular through the establishment of central clearing counterparties subject to effective regulation and supervision.”1 Dodd-Frank and EMIR contain key provisions intended to deliver on this commitment, although implementation timetables and details differ.

While the full extent and timing of the new regulations are still being defined, it is likely that many reforms aimed at major banks and broker-dealers will be implemented during 2012. The broad intentions of the regulators are also clear:

• Increase transparency by pushing OTC derivative trading to central clearing and via swap execution facilities (SEFs) with trade

repositories for the monitoring of all trading activity.

• Reduce counterparty risk by significantly increasing the amount of collateral held against all OTC derivative transactions, whether centrally cleared or otherwise.

Under Dodd-Frank, most banks and broker-dealers will fall under one of two regulatory designations. Most large banks are expected to identify themselves as swaps dealers (SDs). Other institutions that trade swaps in the greatest volumes (smaller banks and broker-dealers, insurance companies, large hedge funds and the like) will be classified as major swap participants (MSPs). Governed by essentially the same set of regulations, SDs and MSPs will be the most affected by the new regulations and are likely to be the first to migrate to the new operating environment. This creates an immediate and pressing series of structural, systemic and, ultimately, strategic challenges.

expected regulation covering cleared tradesUnder Dodd-Frank and similar European legislation, it is expected that approximately two-thirds to three-quarters of the current bilateral trade volume will shift and be cleared through central counterparties (CCPs). When two SDs and/or MSPs enter into a centrally cleared transaction, both will be required to post initial margin, which will be held by the CCP. Variation margin will be passed through the CCP from one counterparty to another. In common with current CCP operating practices, variation margin will move on a T+0 basis rather than the current T+1 model used for bilateral transactions. While institutions trading bilaterally have long been required to post variation margin to account for daily

A recent ISDA paper found that

mandatory clearing called for by

the Dodd-Frank Act would increase

variation margin by $30 - $50 billion

among U.S. banks. Clearing requires

payment of initial margin as well.

The U.S. Office of the Comptroller

of the Currency estimated that

initial margin requirements could

total over $2 trillion globally under

certain circumstances. Other

estimates of initial margin start at

the hundreds of billions of dollars of

new collateral needed.

—derivatiViews, September 6, 2011


price fluctuations, requiring initial margin is new and will substantially increase the amount of collateral required. For initial margin, CCPs will accept only highly liquid, high grade collateral, which will put pressure on supply as demand for this limited pool of collateral continues to increase. The influx of cash resulting from mandatory initial and variation margin is likely to prove challenging to the CCPs who have few options for managing that cash.

expected regulation covering non-cleared tradesWhile most derivatives trades between banks, broker-dealers and other major swaps participants will be subject to mandatory centralized clearing mandates, there will be notable exceptions. Certain instruments will not be accepted by CCPs, principally due to a lack of liquidity, and will thus be exempted. Trades where one of the counterparties is not a financial entity and is using swaps to hedge or mitigate commercial risk will also be exempted (for example, an airline hedging against the price of fuel). The continuing existence of the bilateral market alongside centrally cleared derivatives creates a bifurcated market model which will cause overall costs to rise as bilateral netting is reduced and operational complexity increases.

Margin requirements will vary depending on the regulatory designation of the participants in the trade. As currently proposed:

• Trades between SDs and MSPs: Counterparties must collect initial and variation margin for each trade, which must be held with an independent third-party custodian and may not be rehypothecated. Collateral eligibility will be defined, and haircuts will be specified, by the Commodity Futures Trading Commission (CFTC).

• Trades between SDs/MSPs and non-SD/MSP financial entities: Requirements are the same as above, except the SD/MSP must offer, and the non-SD/MSP may choose, whether or not to have margin segregated.

• Trades between SDs/MSPs and non-financial entities: The SD/MSP is not required to collect margin for each trade but is required to enter into a credit support agreement (CSA). The SD/MSP must offer to keep collateral segregated. Non-financial entities will be allowed to post non-CCP eligible collateral as negotiated with SD/MSP. CFTC rules will not specify haircuts.

While EMIR is approximately one year behind Dodd-Frank, the two are expected to be very closely aligned. Any major long term divergence might result in regulatory arbitrage, something all regulators are carefully watching and seeking to avoid.

impact According to Reece, the sheer breadth and depth of new regulation creates significant challenges for banks, broker-dealers and other major participants in the global derivatives markets. As Dodd-Frank and EMIR intersect with Basel III and a raft of other complex and broad-ranging reforms, it is exceptionally difficult for firms to achieve a holistic understanding of the new market reality. SDs and MSPs are being asked to make major strategic decisions with uncertain inputs. Paltrowitz notes that there are some areas where the likely impact of new regulation is clear:

1. More collateral will be needed. The imposition of mandatory initial margin payments for both cleared and non-cleared transactions, in addition to charges imposed by Basel III for non-collateralization, is forecast to increase

Three Key Implications of Reform

Bifurcated market model, where some derivatives transactions are bilateral while others must be

centrally cleared through a clearinghouse

Requirement to post initial margin for most, if not all, centrally cleared trades

Restrictions on the type of collateral CCPs will accept for initial and variation margin

Limited availability of highly liquid, high grade collateral—already in demand due to other regulatory and capital adequacy reforms

Greater operational complexity

Significant increase in the demand for collateral

1

3

2


Solutions for all Market ParticipantsFor counterparties, J.P. Morgan’s

collateral agency services can

mitigate the operational complexity

of a bifurcated market model while

providing security with segregated

accounts and rigorous reporting.

J.P. Morgan clients benefit from

end-to-end support for both

bilateral and CCP-cleared derivatives

transactions plus a wide array of

options for collateral transformation

and optimization to address the

rapidly increasing demand for higher

volumes, higher values and higher

quality collateral.

For CCPs, J.P. Morgan is also

developing or adapting solutions

to meet their emerging business

challenges, including more efficient

systems to manage their collateral

and expanded options for cash

reinvestment. The use of tri-party

repo (TPR), a long-established

securities collateral management

tool, is one potential solution. CCP

members can open TPR accounts to

more effectively manage their cash

and collateral.

TPR accounts are also one option for

counterparties seeking to transform

their collateral in order to meet the

CCPs’ strict eligibility requirements for

initial and variation margin.

the value of collateral held against all OTC derivatives by $2 trillion, an increase of 50% from current levels.2

2. High grade collateral will be in short supply. Collateral eligibility standards will get tighter under the proposed regulations. Demand will significantly increase for the same high quality collateral called for by Basel III, Solvency II, etc. (essentially G7 government bonds or major currencies). While it is difficult to accurately predict the impact on supply and demand, the consensus is that there will be a significant reduction in availability allied with a commensurate increase in cost. Options for transforming collateral will play a key role in helping institutions meet the more rigorous eligibility requirements set forth by the CCPs.

3. T+0 margin movements will place further demands on collateral. SDs and MSPs will need to keep substantially more eligible collateral on hand, as they will effectively now have to pre-fund all of their OTC derivatives trades with the new requirement to post initial margin.

4. Operational complexity will increase. The introduction of central clearing, coupled with the substantial remaining volume of bilateral trading, will require that two market processes be put in place by virtually all market participants.

5. Collateral optimization will become a strategic priority. As the cost of collateral increases, collateral management and optimization will become the new battleground for efficiency. Those who can efficiently manage margin across cleared and non-cleared derivatives will enjoy a significant competitive advantage.

Finally, and not insignificantly, the CCPs that are requiring initial and variation margin face challenges in holding that cash and collateral. The amount of margin to be held with CCPs will increase substantially, representing a challenge for those institutions as they seek to reinvest cash. Those options are limited. At the same time, the amount of collateral held is also expected to rise as noted above. The current mechanisms for managing collateral are neither sufficient to meet the expected volume nor able to cope with the operational and asset servicing complexities that will ensue.

ConclusionAlthough some of the finer detail remains unclear, Dodd-Frank and EMIR (along with Basel III) will soon become the new reality. Though the rule-making continues, banks and broker-dealers cannot delay their preparation. Managing the interrelation between the new and existing regulatory demands is critical to achieving a favourable outcome for any firm—more critical, in fact, than the demands of any single new reform.

In this context, all the new regulations represent both risk and opportunity. The banks and broker-dealers that adopt and implement the right approach will enjoy a substantially enhanced competitive advantage. Clearly the inverse can also be true.

According to John Rivett, J.P. Morgan business executive for collateral management, “The ability to comingle cleared and non-cleared derivatives trades, and manage the operational complexity of a split market model, requires support for a common approach to collateral management that most market participants don’t currently have in-house.” As a major player in both the cash management and securities servicing markets and an expert collateral agent, J.P. Morgan is uniquely positioned to work closely with all industry participants and bodies to understand the regulations, assess the holistic impact of the changes and devise/propose solutions. Rivett notes that “through J.P. Morgan’s engagement with the regulators, CCPs, clearing members and end clients, we are able to offer a comprehensive range of solutions designed to facilitate the continued use of OTC derivatives while reducing the associated costs of collateral and effectively managing risk.”

Ultimately, whether it is OTC derivatives collateral, exchange-traded derivatives collateral, repo collateral, stock loan collateral or any other collateral, Rivett says that firms are taking an enterprise-wide view of collateral. “Increasingly, institutions are looking at this collectively as ‘collateral’ in order to be truly efficient in their balance sheet usage.” n

1 G20 “Declaration On Strengthening The Financial System,” London, 2 April 2009

2 http://isda.derivativiews.org, September 6, 2011, citing a paper published by The Office of the Comptroller of the Currency (OCC)


Enacted in March 2010, the Foreign Account Tax Compliance

Act (FATCA) was conceived as a means to ensure the

collection of tax revenues for U.S. persons holding

offshore accounts with foreign financial institutions

(FFIs). Broadly, this law imposes a new withholding and

reporting regime upon all FFIs that invest directly or as

an intermediary in U.S. assets. These withholding and

reporting requirements add another layer of rules to

the existing withholding and reporting rules, including

the Qualified Intermediary regime.

Countdown to the Foreign Account Tax Compliance Act

Key FAtCA requirementsWhen fully effective, FATCA will

require an FFI to conclude an FFI Agreement directly with the U.S. tax

authority, the IRS, to identify its U.S. account holders and annually report information about their accounts. In addition, an FFI will be required to withhold tax on “passthru payments” made to so-called “recalcitrant” account holders (account holders who are unresponsive to information requests by an FFI undertaking account identification procedures) and to FFIs that are not themselves compliant with FATCA. Finally, if local privacy laws would prevent the FFI from reporting information about a U.S. account holder, the FFI would be required to request the account holder to waive the privacy law or to close that account if a waiver is not provided.

An FFI that fails to comply with FATCA’s due diligence and reporting

requirements will be subject to a 30% withholding tax on “withholdable payments”—i.e., certain U.S.-sourced payments, including bank deposit and other interest, dividends and gross proceeds on the disposition of U.S. debt or equity securities.

Definition of foreign financial entity and non-financial foreign entityThe definition of FFI is broad and includes financial institutions that accept deposits (such as all types of banks), hold financial assets for the accounts of others (such as custodial banks, trust companies, broker-dealers, etc.), or engage in an investment business (such as mutual funds, hedge funds, private equity funds, etc.).

IRS guidance issued to date has limited exemptions to the FFI definition. These exemptions include, for example,


rebecca i. wolffSenior Tax Manager, Global Tax Services Group

insurance companies that do not issue cash value insurance products or local banks with no operations or accounts outside of their country of organization. Although the law enables the IRS to exempt from FATCA those companies it deems to pose a low risk of tax evasion, the IRS has so far identified only certain foreign retirement plans as posing such low risk. The IRS has, however, suggested that it continues to study additional exemptions for other types of financial institutions, including certain collective investment vehicles and other investment funds. Accordingly, forthcoming regulations may contain additional exemptions from the law. The IRS has not included any exemptions to the FFI definition that have been advocated by foreign financial institutions.

FATCA identifies foreign companies that do not fall into the FFI category as non-financial foreign entities (NFFEs). NFFEs are likewise subject to a 30% withholding tax on U.S.-sourced payments where U.S. persons hold an ownership interest exceeding 10% in the NFFE, unless such NFFE reports certain information about those U.S. owners.

The bulk of FATCA’s impact is on FFIs because NFFEs generally have broad exclusions. For example, publicly traded companies and their affiliates, as well as NFFEs that are engaged in an active trade or business, are exempted from the law. Presumably, these types of NFFEs pose little risk of enabling U.S. persons to evade U.S. tax.

Definition of withholdable payments Under FATCA provisions, “withholdable payments” include U.S.-sourced payments such as interest on bank deposits, as well as all interest, dividends and gross proceeds from the disposition of U.S. debt or equity securities.

Passthru paymentsA passthru payment is any payment to the extent it is attributable to a withholdable payment. By requiring FFIs to withhold tax on payments made to non-compliant FFIs (i.e., passthru payments), even FFIs that do not invest directly in U.S. assets will need to enter into an FFI Agreement with the IRS. The passthru payment rule effectively prevents a participating FFI from being used as a “blocker” through which non-compliant FFIs might benefit from indirect investments in U.S. assets.

refundsFATCA does provide for refunds of the withholding tax (albeit without interest), but only to the extent that the FFI receiving those payments as a beneficial owner is entitled to a reduced rate of tax under an applicable income tax treaty with the U.S.

implementation datesAlthough FATCA is technically effective on January 1, 2013, the IRS plans to implement the law under a phased approach. Under the IRS’s plan, FFIs must enter into the FFI

Agreement by June 30, 2013 in order to avoid potentially being withheld on beginning January 1, 2014. Annual reporting for U.S. accounts identified by June 30, 2014 will begin by September 30, 2014. Withholding will begin in 2014 for periodic-type payments such as interest and dividends paid after December 31, 2013, and in 2015 for gross proceeds paid after December 31, 2014.

Full details on FATCA’s implementation are not yet known, but the IRS is expected to issue proposed regulations by the end of 2011 followed by finalized regulations by the middle of 2012. We also expect to see draft versions of the FFI Agreement and modified U.S. tax certification forms (e.g., Form W-8’s) sometime in 2012.

FATCA represents a major challenge to financial institutions as it will require implementation of new on-boarding procedures and technological and systems enhancements, as well as extensive due diligence on existing customer accounts. At the same time, complying with FATCA will be necessary for any financial institution that wishes to continue serving clients investing in the U.S. market. n

Key terms

FOreiGn FinAnCiAL inStitUtiOnS (FFIs) include those that accept deposits

(such as all types of banks), hold financial assets for the accounts of others (such as

custodial banks, trust companies, broker-dealers, etc.), or engage in an investment

business (such as mutual funds, hedge funds, private equity funds, etc.)

witHHOLDABLe PAyMentS include U.S.-sourced payments such as interest

on bank deposits, as well as all interest, dividends and gross proceeds from the

disposition of U.S. debt or equity securities.

PASStHrU PAyMentS are any payment to the extent it is attributable to a

withholdable payment.


SheenaghGordon-Hart

Industry and Client Research

Executive

After almost three years of unrelenting regulatory change, will there be any reprieve for asset managers? Is there yet more to do? UCITS V, changing attitudes of non-EU regulators to UCITS, corporate governance and eligible assets: all are on the industry agenda—any of these might change product mix, distribution strategies and business models. Finally, how does J.P. Morgan see the future?

New Challenges Ahead Will Test Asset Managers


The European asset management industry has reason to be proud of its achievements. Assets under management stood at 13 trillion at the end of 2001 but had reached 17.89 trillion by the end of Q2 2011. UCITS make up 74% of the funds in Europe and are, without doubt, one of the most successful products of Europe’s single market project. No longer a new concept, they have been around for more than a quarter of a century, and over this time they have evolved and adapted to meet the needs of today’s more sophisticated investors. This is due in no small part to the engagement of European policymakers who have framed regulations that provide increased flexibility in terms of eligible assets.

For example, the original idea of creating a product framework that would be eligible for cross-border marketing in European Union Member States has been a success; cross-border sales now account for almost 80% of net European funds sales.1 But more than that, UCITS has a global marketplace with regulators as far afield as Asia and Latin America accepting the brand. In 2005 the Hong Kong regulator, the SFC, was the first Asian regulator to accept UCITS III funds. This is good news for asset managers because there are limits to the scale that can be achieved by marketing solely in Europe, although there are still significant opportunities, not least in competing for the often sizeable non-managed portion of household financial assets, i.e., cash.

The charts on the right compare the proportion of cash in household financial assets for France, Germany and the United States. The data demonstrates that in some countries there is still a significant allocation of cash savings by households, and it is these “unmanaged” savings that provide a considerable opportunity for asset managers.

However, since 2008 the regulatory environment has shifted. We are now facing an unprecedented tsunami of regulations on both sides of the Atlantic, with the reform agenda framed by G20 commitments. Asset managers will have to adapt.

the Dodd-Frank ActThe U.S. chose to meet its G20 commitments in the wake of the financial crisis with one sweeping piece of legislation, the Dodd-Frank Wall Street Reform and Consumer Protection Act. Although it runs to more than 2,000 pages in final form, it devolves much of the detailed rule-making to regulatory authorities, such as the Commodities Futures Trading Commission (CFTC) and the Securities Exchange Commission (SEC). The Act delivers a thorough reform of the U.S. financial system aimed at creating transparency, particularly in the derivatives space, with the mitigation and early warning of emerging systemic risk. It also includes the creation of a range of new regulatory agencies. Asset managers in

Household Financial Assets

15% United States CASH

MUTUAL FUnDS

LIFE

PEnSIOn FUnDS

6%

25%54%

France CASH

MUTUAL FUnDS

LIFE

PEnSIOn FUnDS

31%

14%

34%

21%

Germany CASH

MUTUAL FUnDS

LIFE

PEnSIOn FUnDS

39%

26%

17%

18%


Europe who have business in the U.S. need to be aware of the new registration requirements, which unless exemption can be obtained, are onerous. The existing private investment advisor exemption which many non-U.S. managers relied upon has been eliminated and replaced with new requirements. Fortunately the original date for registration (July 2011) was extended by the SEC; applications must now be submitted by March 2012.

european initiativesIn Europe, the approach to G20 commitments has taken a different path with a number of regulatory initiatives coming in to deal with different elements of the perceived problem. For example:

• Alternative Investment Fund Managers Directive (AIFMD), aimed at dealing with hedge funds (but capturing a whole range of other product types in its wake), and

• European Markets Infrastructure Regulation (EMIR), part of the EU’s response on derivatives.

In common with the United States, Europe has also re-cast its regulatory structures and introduced new regulatory authorities, including the European Securities and Markets Authority (ESMA) which replaces the Committee of European Securities Regulators (CESR).

The first post-crisis legislative change in Europe, AIFMD, was aimed squarely at asset managers. The Level 2 detailed rules that give substance to the Directive are currently being drafted, and we will not know the outcome until January 2012 at the earliest. What we do know, however, is that elements of AIFMD will be incorporated in the next round of UCITS regulation in the guise of UCITS V. In particular, it is expected that UCITS V will reflect the provisions of AIFMD as they affect depositaries. It would be inappropriate for the alternatives world to be subject to more prescriptive rules than those applicable for UCITS, which were originally conceived as a type of fund that would be suitable for retail investors.

In addition, a discussion paper on ETF UCITS and structured UCITS was published in July. This followed reports on the use of derivatives by ETFs by the International Monetary Fund

(IMF),2 the Bank for International Settlements (BIS)3 and the Financial Stability Board (FSB).4 The initiative from ESMA follows their review of the regulatory regime pertaining to UCITS ETFs and structured UCITS from which ESMA concludes that “the existing requirements are not sufficient to take account of the specific features and risks associated with these types of fund.” The ETF market is a small part of the mutual fund universe, and plain vanilla ETFs still dominate with an estimated 85% of ETF assets globally. However, according to the Financial Stability Board, 45% of European ETFs are synthetic, and this is due in part to derivatives being categorized as “eligible assets” for UCITS. The SEC also published on 31 August 2011 a concept release with a request for comment on the use of derivatives by U.S. mutual funds.

Change for UCITS is clearly in the air. Under the Markets in Financial Instruments Directive (MiFID), UCITS that use derivatives will be categorized as complex (whereas now UCITS are generally deemed as non-complex). What then are the implications for distribution? In addition, or alternatively, will the Eligible Assets Directive be redrawn to restrict the use of derivatives? If so, will asset managers utilizing hedge fund-type strategies perhaps opt-out of UCITS altogether and seek authorization as AIFMs?

It has been said that the AIFM “badge” will evolve to become a global standard as has UCITS. In my view this is unlikely, in part because a UCITS is a fund whereas an AIFM is a manager, and there is very little heterogeneity in the countless types of non-UCITS that are within scope.

There are, of course, items on the change agenda that did not emerge from the G20 commitments. Solvency II pre-dates the financial crisis, but when it comes into force on 1 January 2013 it will significantly add to the reporting burden for those asset managers with insurance clients. In recent months both the Council of the European Union and the European Parliament’s Committee on Economic and Monetary Affairs have called for a further delay until 1 January 2014. Regardless of whether an extension is granted, insurers and their advisors will need to make significant changes to the way they operate and report. All of this will be time and resource intensive at a time when there are so many other regulatory changes that require attention.

implications of FAtCAAnother non-crisis related change is the U.S. Foreign Account Tax Compliance Act (FATCA). This has truly daunting implications for asset managers around the world. FATCA aims to eliminate opportunities for U.S. tax evasion by requiring the identification of U.S. account holders and imposing reporting obligations on non-U.S. financial institutions, e.g., foreign financial institutions (FFIs) and non-

Change for UCITS is clearly in the air. Under

the Markets in Financial Instruments

Directive (MiFID), UCITS that use

derivatives will be categorized as complex

(whereas now UCITS are generally deemed

as non-complex).


U.S. non-financial foreign entities (NFFEs). If no information is provided to the IRS, FATCA introduces a 30% withholding tax on “withholdable payments” which include, inter alia, interest dividends and rents, as well as gross proceeds on disposal of any property that can give rise to U.S. source dividends or interest.

Clearly, asset managers with extensive, often remote distribution networks will find it very difficult and costly to comply with FATCA. There has been extensive lobbying for an exemption for widely held mutual funds. The legislation for FATCA is being supplemented by a series of IRS5 and Treasury Notices that provide further details and guidance. However, the rules are not yet final. There has been an extension of the implementation timeline for certain withholding obligations:6 originally FATCA was due to be effective from 1 January 2013, but this has now been pushed back to 1 January 2014. An FFI must now register as a participating FFI by 30 June 2013 in order to avoid being withheld on beginning 1 January 2014.

FATCA presents an enormous challenge for asset managers unless some measure of exemption can be obtained, perhaps by being categorised as “deemed-compliant FFIs.” Currently, deemed-compliant FFIs include certain local banks, local FFI members of a participating FFI group and certain other investment vehicles. In respect of the latter category, a fund may be deemed-compliant if:

• All the investors are participating FFIs or deemed-compliant FFIs or are FFIs exempt from all FATCA withholding.

• The fund prohibits subscription by any entity not falling into the preceding categories.

• The fund certifies that its passthru payment percentages will be published quarterly.

It is unlikely that asset managers will be able to seek deemed-compliant status, and they cannot afford to ignore FATCA. Asset manager business models are complex; their distributors are scattered around the world; they have product sets that include U.S. portfolio allocations—and some non-U.S. stocks that have U.S. source income. They will have to undertake detailed screening of their investor base to identify U.S. investors and “recalcitrant” investors; this may appear straightforward, but it is not. In reality, few asset managers have substantial exposure to a direct client base—platforms and intermediaries have served to anonymise the client. This, unfortunately, does not remove the obligation to respond to—and comply with—FATCA. The U.S. aims to capture US$7.6 billion from FATCA over a period of ten years. (Further information concerning FATCA can be found on page 8.)

Looking aheadThe next two to three years will be extremely difficult for the industry as the wave of new regulations tests the resilience of the mutual fund industry. For European asset managers, the lure of Asia as a distribution hub may be subject to strain: a number of regulators in Asia have voiced concerns over the use of derivatives by UCITS, echoed now by ESMA. In addition, the long-discussed Asian fund passport is becoming a distinct possibility. Currently 90% of all offshore products sold in Asia derive from Europe. This could change if mutual recognition and cooperation between Asian regulators is successful. It would be a serious set-back for European UCITS.

Looking to the future, it is hard to predict whether the current momentum in UCITS will continue. Distribution is the lifeblood of the fund industry; the business model predicated on a European hub for globally distributed products is under threat. That is not to say that asset managers will be unable to “follow the money;” their skill in product design and innovation is easily transferable, and if local product is a requirement for Asian investors, then local products there will be.

However, the way European UCITS are distributed in Europe is also worth looking at, since for markets where proprietary distribution is dominant (France, Germany, Italy, Spain) the focus of the sales effort is new products. This contrasts with the UK where IFAs are the dominant sales channel. In the UK, the vast majority of sales are directed to established funds (85% in 2010), not newly launched products. It must be noted though that the Nordic markets, where bancassurance dominates, follows the UK in favouring “backlist” products, although these markets are small. The UK’s experience mirrors that of the U.S., where on average 90% of sales are into mature funds. The never-ending cycle of new products really needs to be addressed. Perhaps it is this that explains the enormous number of mutual funds in Europe: at end 2010 there were 35,292 European mutual funds with total net assets of US$7.9 trillion. In the U.S., by contrast, there were just 7,582 mutual funds with assets of US$11.8 trillion. It is, in part, the size of the average U.S. mutual fund that explains their advantage in terms of expense ratios and returns.

UCITS will need to find a new axis for growth: this could be built around the need in Europe for some form of pan-European pension saving arrangement. If this could be accommodated within the UCITS framework then there may be opportunities for the asset management industry to capture this potentially enormous market. The scale challenges of the European industry are well-rehearsed and UCITS IV provides some of the tools that enable the industry to address this. However, there has been very little interest in


master-feeder arrangements or mergers because many obstacles remain. The fund industry is just one part of the financial services landscape. Other sectors, banks, broker-dealers, insurers and others are all subject to the increasing regulatory burden. In particular there are more stringent capital and/or solvency requirements as well as much higher compliance costs to be addressed. These are likely to play a part in reshaping the industry, shaking out the weak and offering opportunities for growth. This may be the catalyst that begins to remove large numbers of

essentially moribund funds from the market and lays the groundwork for scale—a better deal all round for the investor. n

1 Source: Lipper2 Global Financial Stability Report, April 20113 BIS Working Papers no. 343, “Market structures and systemic

risks of exchange-traded funds,” April 20114 “Potential financial stability issues arising from recent trends in

Exchange-Traded Funds (ETFs),” April 20115 IRS Notices: 2010-60: http://www.irs.gov/pub/irs-drop/n-10-60.

pdf, 2011-34: http://www.irs.gov/pub/irs-drop/n-11-34.pdf, 2011-53: http://www.irs.gov/pub/irs-drop/n-11-53.pdf

6 In respect of dividends, interest and certain other U.S. source payments

Patrick O’Brien

European Fund Distribution

Executive

requirements and local buying behaviours via distributors, banks or platforms can present many challenges.

The fragmented nature of the distribution model is evidenced by key elements, including local country tax reporting as well as varied commission structures and share class hedging. This highlights the ineffectiveness of attempting to compare the structure of a local market such as the U.S. or UK with one that tries to accommodate cross-border variations and client requirements.

ChallengesThe global distribution opportunities presented by a UCITS fund also represent its greatest challenge—namely the ability to market into many jurisdictions and to different types of investors worldwide.

The key drivers of change that we have observed in the past few years are far from temporary. Regulation and change are set to cause a significant shift in our thinking and our servicing strategies and have the potential to disrupt global distribution models.

The uncertainty of these changes and their impact dominate our thinking and the strategies of our clients. It is more important than ever for securities services providers to remain at the forefront of regulatory change, to understand

And How Will the Resulting Regulations Impact Global Fund Distribution?The key to the success of UCITS is its ability to passport

freely cross-border within the EU and to distribute

globally from recognised and specialist domiciles such

as Ireland and Luxembourg.

The turmoil created by the global financial crisis in 2008 has expedited a raft of regulatory reform and change. One of the questions outstanding is how these regulatory changes will impact the current UCITS fund distribution model and what will the impact be to investors?

Upcoming changesLuxembourg and Ireland are the two main domiciles of choice for fund promoters seeking to establish UCITS funds that will be marketed cross-border, i.e., mutual funds that will offer more than just domestic distribution. Over the years, these two fund centres have developed the necessary infrastructure and skilled workforce to service UCITS funds for international investors.

The distribution model facilitating this growth has evolved over the last 25 years with new markets opening up, new developments in fund structures and greatly enhanced technology. As a result, the concept of global distribution can be confusing and often hard to navigate. Identifying a single distribution model that can accommodate a diverse range of regional


the complexities of distribution and to help prepare their clients for the challenges ahead.

The UCITS directive has its own legal framework, which has recently been amended under UCITS IV. This provides more stringent rules but also provides opportunities for efficient fund consolidation and a more effective cross-border registration process.

One of the challenges facing fund promoters under UCITS IV is the introduction of the new and obligatory Key Investor Information Document (KIID). This mandatory one-page document is a sound objective although its practical implementation is not straightforward. It will help maintain transparency by providing the investor with key information on the fund in a consistent format. However, the KIID presents an additional reporting burden on distributors/fund managers, as production is complicated by translation requirements and the cost of disseminating the material. It is precisely the practical implementation that needs to be addressed when considering all the proposed regulations that will undoubtedly impact the current distribution model. Who will be held accountable for implementing the changes and where is the burden being placed—on the asset managers or the distributors?

Whilst not always straightforward, the current distribution model works well and allows asset managers to reach their investors by selecting appropriate fund features, platforms or distribution channels. Whether the intention is to protect the investor base or to provide further transparency, we need to understand how the adoption and implementation of regulatory change will alter existing access points and, fundamentally, what cost will the funds industry incur by facilitating these new demands. Investor requirements will essentially remain the same—they will continue to seek returns on investment products that they can access and understand. However, additional reporting

requirements may negatively impact the total expense ratio (TER), and the returns could ultimately make the products undesirable. Therefore, creating an efficient future model to accommodate these requirements is critical to the continued asset growth and appeal of the UCITS domiciles.

what next?The increase in regulatory initiatives will require specific technology development efforts, i.e., to accommodate reporting for Solvency II or FATCA. Many service providers are already preparing for the combined impact of the changes and the effect the new regulatory environment will have on the fund features, structures and distribution channels.

UCITS V is awaiting the final scope of upcoming reforms, including MiFID II and AIFMD, before it takes shape. RDR (Retail Distribution Review), PRIPs (Packaged Retail Investment Products) and Dodd-Frank will all necessitate changes to the core infrastructure of the fund administrator in order to cater for new share classes, commission and distribution capabilities, and enhanced reporting. There is little doubt the distribution model will change; the ability to understand and anticipate these changes will set the market leaders apart in the coming years. Leveraging a partner with a global footprint, experience, ongoing investment and tacit knowledge on the fundamentals of this distribution model will provide clients with the confidence to design these solutions and continue to prosper in the face of this constantly evolving landscape. n

Regulator, Legal & Auditing

Asset Manager (Brand & Offering)

Administration Infrastructure & Capabilities

Asset Gathering Sales Force

Distributors / Platforms / Sales Channels

Investors / Shareholders

The Distribution Value Chain

The Distribution Model

UCITS IV & V

MiFID II

AIFMD SOLVEnCy II

RDR / PRIPS

FATCA

FUnDS DISTRIBUTIOn


The Resurgence of Private Equity in Asia

The reemergence of this asset class has raised several key questions for private equity investors: what are the private equity trends in Asia? How are my peers engaging with private equity? What can I do to better understand and take advantage of opportunities in this evolving asset class? How can a portfolio administrator assist in navigating this changing environment? What resources are available to help me understand the performance and provide transparency for this unique asset class?

the private equity tide is risingRecent market intelligence has highlighted an increased focus on private equity from investors. The private equity industry peaked in 2007 and was quickly followed by post-crisis lows in 2009-2010; however, the tide is again rising across key fund sponsor and investor metrics. Specifically, there have been notable increases in fund raising, fund size

and investor allocation to private equity across the globe in 2011.

The first half of 2011 witnessed US$140 billion in fund closes, which was on track to exceed 2010’s post-crisis low of US$260 billion. Additionally, the average fund size as of summer 2011 jumped to US$496 million, up from US$431 million in 2010.1 This highlights the increased strength of the private equity fund market compared to the lows of 2009-2010. In line with these increases in fund activity, it is anticipated that there will also be increases in investor allocation to private equity. According to Coller Capital’s Global Private Equity Barometer—Summer 2011, 27% of investors have articulated planned investment increases in private equity. This is up significantly from the same period in 2009 in which only 17% of investors articulated a planned increase in the asset class.2

Funds focused on AsiaWhile there is a healthy mix of fund sponsors launching funds both locally in Asia as well as in traditional offshore locations, the underlying investment trend for fund sponsors is clear: investment will be focused on Asia-based companies and properties. The industry has

The private equity landscape in Asia is poised for change. As

the global economy recovers from its contraction of 2008-2009,

private equity has reemerged as a key focus for investors looking

to build out a diversified portfolio.


Matthew GoldblattAsia Pacific Regional Product Manager, Private Equity and Real Estate Services

witnessed many funds aimed at investment in Asia. In the last three years, 70% of emerging market funds were invested in Asia and this percentage is growing, representing the single largest proportion of fund investment globally.3

Sovereigns investing in private equityAs the private equity market expands, sovereign wealth funds (SWF) are expected to play a significant part in its growth. In 2010, the percentage of SWF invested in private equity increased from 55% to 59%, and interest from SWF to invest in this asset class continues to grow.4 While SWF represent only a small portion of investors in private equity, they do represent a relatively large percentage of private equity investment dollars.

transparencyA key consideration when investing into private equity is: how much transparency into the underlying investments is available in the market? While the answer to this question varies by investment strategy and structure, investors are unanimous in demanding a better understanding of their investments in an industry that for many years has been considered “opaque.”

While general partners will often report a single fund’s underlying investments to their investors, sophisticated investors want to understand the collective underlying holdings of their portfolio.

A good portfolio reporting and analytics administrator must address:

• What is the aggregate value of their underlying investments in Asia?

• Are the same underlying companies held in multiple funds managed by different general partners?

• How much vacant cubic feet do I have across all of my real estate investments?

The ability to gain this transparency into an investor’s portfolio exists; uncovering the answers to these fundamental questions may have a profound impact upon investment decisions.

regulationAs the private equity industry expands with the introduction of new funds, new markets and new investors, regulatory reform is anticipated around the globe. In the EU, the Alternative Investment Fund Managers (AIFM) Directive may increase its supervision of funds and costs to operate a fund. This could impact the strategy and location of funds in the market and trigger additional considerations for investors globally who are scoping European funds.

Further, Dodd-Frank may require increased transparency of investments via U.S. accounts, which may lead to increased reporting requirements for both funds and investors globally.

While it is too soon to quantify the regulatory impact on private equity, discussions with investors have revolved around regulation, increased investment in this particular asset class, and the need for transparency in their investments.

Unique period aheadPrivate equity is currently a highly salient topic among Asian investors. Given its reemergence as an asset class for investors globally, and with an increased emphasis on Asia, we anticipate the next 18 months to be a profoundly unique period for Asia as a region—for private equity fund sponsors and for investors alike. n

1 2011 Preqin Global Private Equity Report2 Coller Capital, 20113 Preqin, 20114 Preqin, 2011

Percentage of Investors Planning an Increase in Private Equity Investment50

40

30

20

10

0

2007 2008 2009 2010 2011

S U M M E R

47%

38%

17%20%

27%

Source: Coller Capital Barometer 2011, survey of 110 investor LPs globally


Brazil illustrates how, in the long run, a fully regulated environment can

prove to be beneficial for the funds industry. This is especially true for

hedge fund managers, for whom Brazil’s environment provides security,

independence and a level playing field in which to operate.

Accessing the Brazil Market


Pedro SalmeronVice President, Sales & Business Development

For foreign investors attracted to the emerging global success of Brazil, the country’s environment is often regarded as one of the world’s most complex, particularly for alternative fund managers. And in truth, there are a number of good reasons for such an assessment.

Since the 1990s the Brazilian economy has experienced a series of changes that have substantially enhanced financial flows both into and out of the country, supported by regulatory improvements which have increased accessibility to the capital markets. However, it is important to understand these developments against the background of Brazil’s consistent regulatory environment. The country has multiple regulatory bodies governing registration of all fund market participants and reporting requirements with associated daily processes (see regulatory authorities table on page 20 for a brief description of each entity).

First, the steps around registration requirements pose an initial cost to asset managers. All financial institutions in Brazil, from a single individual distributor to a large institutional custodian, must be registered.1 In addition, the Brazilian market mandates additional reporting above and beyond the threshold that investors from other markets may not be accustomed to. For example, investors benefit from daily net asset value calculations (NAV) for all funds (including long-term private equity funds) as well as daily monitoring of all trades and respective compliance rules.

Brazil’s environment: excessively challenging or a model environment?While some might argue that such an investment environment is excessively demanding, the overall trend in world markets towards a culture of increased regulation and disclosure contradicts this point of view. One illustration of this sobering reality is the fact that, in the wake of the 2009 conviction of Bernie Madoff, the self-regulatory nature of the global funds industry has been challenged.

Historically healthy inflows One ironic effect of this trend has been that Brazil has become a global model of how overall intelligent guidance and regulation does not necessarily limit business opportunities. On the contrary, the country’s domestic funds industry has grown consistently over the last 20 years. All of this has evolved reasonably smoothly.

Over the years, there has been a healthy inflow of investment into the Brazilian market. The country is quite open to foreign investment in its capital markets, and foreign investors enjoy an established environment in which to oversee portfolios.

Recent reform in regulating outflows In contrast, outflows have been more of a challenge. Today, however, sophisticated Brazilian investors can obtain exposure to non-Brazilian assets by using local feeder funds (though not yet through local exchange-traded funds [ETFs]).

While investors’ ability to invest offshore has opened up, Brazil’s regulators remain vigilant and have instituted significant precautions to protect the final investor. The local custodian is responsible for ensuring that all the positions are reconciled on a daily basis. This includes a daily substantiation process for any assets with offshore custodians.

With the still-high interest rates on local public bonds, outflows from Brazil have not yet demonstrated strong growth. This is also due to cultural practices, as Brazilian managers and investors still tend to view offshore investing as venturing into uncharted waters.

Nevertheless, for offshore alternative fund managers interested in Brazilian investors, the current timing is quite good. For example, private banking in Brazil has never been so vigorous, and high net worth individuals’ interest in new products and partnerships is an important trend in this market. In addition, on the retail side, big local banks are offering funds with offshore exposure as part of their menu of typical investment products.

Conclusion: the Brazilian opportunity From the point of view of a European or U.S.-based asset manager, some new opportunities are now available. Together with the country’s positive economic trends, this change has definitively upgraded Brazil’s position on many asset manager CEO’s list of “Next Places To Set Up an Office.”

Today, U.S. and European markets alike are struggling to understand and absorb the significance of new regulatory initiatives such as Dodd-Frank and Alternative Investment Fund Managers Directive (AIFMD). While some see these as a constraint on the industry, others point out that the ultimate impact of new regulatory initiatives on these developed markets is unknown.

In contrast, Brazil’s well-established environment has always been a part of the country’s investment market and culture. In fact, in recent years, including the credit crunch, it has come to be regarded as quite beneficial to the financial industry.

Together with these outflow windows for funds, a whole new field of possibilities has opened up in Brazil, in the

Accessing the Brazil Market

Montserrat Serra-JanerVice President and Relationship Manager


CMn comprises the finance minister, the planning and budget minister, and the Central Bank governor. It was created with the specific purpose of formulating monetary and credit policies for the financial and capital markets. CMn policies address matters such as the availability of credit, payment for credit transactions, operating limits for financial institutions, and the rules governing foreign investment and foreign exchange in Brazil.

The Central Bank is a federal agency attached to the finance ministry and is responsible for implementing the monetary and credit policies established by CMn, regulating the foreign exchange market and capital flows, authorizing new financial institutions, supervising existing institutions, and overseeing the operations of public- and private-sector financial institutions, including the power to apply penalties. The Governor of the Central Bank is appointed by the president of Brazil, subject to confirmation by the Federal Senate, for an indefinite term of office.

CVM is a federal agency attached to the finance ministry and is responsible for regulating and overseeing the Brazilian capital markets. Financial institutions and other institutions authorized to operate by the Central Bank are also subject to regulation by CVM when conducting business in the capital markets. One of CVM’s key responsibilities is to oversee the activities of publicly held companies, organized over-the-counter (OTC) markets, exchange markets, and commodities and future markets, as well as members of the securities distribution system, such as fund managers and asset managers. CVM characterizes a market as an organized exchange or organized OTC market, depending primarily on the pricing rules adopted for trading platforms or systems, the volume traded, and the type of investor targeted. BM&FBOVESPA falls under the organized exchange category.

The company develops, implements and provides systems for the trading of equities, derivatives, fixed income securities, federal government securities, financial derivatives, spot foreign exchange and agricultural commodities; It has a settlement bank and four clearinghouses for the registration, clearing and settlement of transactions carried out on its trading systems; It also acts as a central securities depository, and licenses software and stock indices. The company further manages social investments with focus on developing the communities with which it interacts.

Representing over 340 institutions, including commercial, multiple and investment banks, asset managers, brokerage houses, securities distributors and investment consultants; Helping Brazilian public institutions to regulate the activities of the financial and capital markets agents; Providing research and statistics about financial and capital markets.

national Monetary Council (CMn)

Central Bank of Brazil (BACEn)

Brazilian Securities and Exchange Commission (CVM)

BM&F BM&FBOVESPA (Brazilian Mercantile and Futures Exchange and São Paulo Stock Exchange)

Brazilian Financial and Capital Markets Association (AnBIMA)

AUTHORITy COMPETEnCIES/FUnCTIOnS

Brazil Regulatory Authorities

process shifting the market’s overall complexity to a higher level. Combined with the country’s significant and sustained upward economic trends, investing in the financial markets in Brazil has become an attractive proposition.

With a presence in Brazil for more than 50 years, J.P. Morgan offers services across the Investment Bank, Global Corporate Bank, Asset Management, Private Banking and Treasury & Securities Services. The firm has a strong local presence with offices in São Paulo, Rio de Janeiro, Porto Alegre, Curitiba and Belo Horizonte. Clients benefit from the firm’s global expertise and strength across Latin America. Since September 2011, J.P. Morgan’s global custody clients with interests in Brazil have used J.P. Morgan as custodian. n

1 Registration of the funds market participants in Brazil requires compliance with all documentation and authorization requirements with the CVM and Anbima (self-regulatory entity), apart from other specific regulatory bodies. Initial registra-tion usually requires an audit report stating the current and planned state of the provider’s systems, process and staff structure. Similarly, all funds also require registration, and the disclosure and documents requirements depend on the type of fund, target investors and distribution (public or restricted).

This article is for informational purposes only, and the information contained herein may change at any time without previous notice or communication. It is intended neither to influence your investment decisions nor to amend or supplement any agreement governing your relations with J.P. Morgan. J.P. Morgan shall not be liable for any damages or costs whatsoever arising out of or in any way connected with your use of the mentioned information. J.P. Morgan does not warrant or assume any legal liability or responsibility for the accuracy, completeness, or usefulness of any information herein provided, and gives no representations whatsoever as to the legal, regulatory, financial, tax or accounting implications of the matter in this document. © 2011 JPMorgan Chase & Co. All rights reserved. Ombudsman J.P. Morgan: Tel: 0800 – 7700847 / E-mail: [email protected]


Pensions’ Reform in Europe

In Europe, the issue of pensions is never far from the top of the agenda. The stresses and strains of a radically worsening demographic profile are felt in most countries’ public and private finances. For Member States of the European Union, there is little homogeneity in pension provision. In several countries the principal provider of retirement income is the state—or more accurately, the taxpayer; in yet other Member States, there is a mix of funded private and public provision. As populations around Europe age (and they are ageing rapidly),

The European Commission recognises that a hallmark of Europe’s pension systems is

fragmentation. A consultation from the European Insurance and Occupational Pensions

Authority (EIOPA)1 suggested a number of options for remedying the perceived weaknesses

and creating a more robust European pensions framework. Are the options available

sufficient? What else should be considered?

so public finances are stretched ever further, and the European Commission has decided that action is required.

europe is shrinking and ageing The challenge of Europe’s ageing population cannot be underestimated; there has been a rapid and historically unprecedented decline in fertility with Europe as a whole now well below replacement rate and facing the prospect of the population halving within 45 years.2 Although


the United States also has an ageing population profile, its fertility rate is higher, its population is growing and it can readily absorb significant immigration flows.

For Europe, the difficulty is that many EU Member States have very little by way of private, funded pension provision and rely principally on the public purse. For example, as shown in the chart below, pension assets in France stand at only 5% of GDP compared to much higher ratios for countries such as the UK and the Netherlands. In France, the compound annual growth rate of pension assets over the last 10 years has been only 0.9% compared with 5.1% for the Netherlands and 5.8% each for Germany and the UK. With the dependency ratio rising inexorably as life expectancy increases, so there will be massive demands made on the taxpayers for pensions and other welfare benefits. And with the population shrinking, the fiscal burden will be vast.

The wide differences in approach to pension provision across Europe pose a problem for policymakers. There is a general objective of harmonisation across Europe, and this has been successful in a number of areas. However, a “one size fits all” solution in the area of pension provision could be hugely disruptive

and potentially costly, given, in particular, the complex inter-relationships among pension entitlement, social security systems and taxation. The European Commission wants to create a common framework for pensions, but ironing out the differences may not be the right way to proceed.

The high-level objectives the Commission has set out (see side-bar) are commendable and no one could disagree. I would, however, caution that existing arrangements for the provision of pensions across the EU do not easily lend themselves to harmonisation since they reflect the unique combination of legal, economic, welfare and social traditions of the particular Member State.

A focus on governanceIn this first phase of EIOPA’s consultation, the extent to which Solvency II can be copied across to IORPs, as it is intended to apply to insurance undertakings, begins to be explored. EIOPA asks if the governance standards of Solvency II are appropriate. The industry’s answer is likely to be yes and no. Harmonisation of best practice at European level is a laudable aim, but to be effective these standards need to be very high level, accommodating the different approaches and structures for pension provision in each Member State. In the context of governance, EIOPA asks whether Solvency II’s “Fit and

Pension Assets as % GDP

140%

120%

100%

80%

60%

40%

20%

0%

Source: Towers Watson, February 2011

France Germany UK netherlands U.S.

For Europe, the difficulty is that many EU Member

States have very little by way of private, funded pension

provision and rely principally on the public purse.

5%14%

101%

134%

102%


SheenaghGordon-HartIndustry and Client Research Executive

Proper” requirements should apply for those who run the undertaking or have key functions. In principle the answer is yes, but Article 42 of Solvency II calls for professional qualifications, and here the UK’s approach to governance would not sit comfortably with this requirement. In the UK, the duties and responsibilities of lay trustees are at the heart of governance; trustees play a pivotal role in ensuring that the interests of members are protected. Should this tried and tested tradition be set aside in the interests of harmonisation, or would it be better to adopt high level requirements that would not necessitate a complete overhaul of the system? This is just one example of many that illustrate the diversity of pension provision in the EU and which suggest that higher level standards of good governance should be the goal with allowance for such differences.

Greater pension choice at lower costExisting funded occupational pension arrangements take different forms across Europe, but in my view it’s not the differences that matter. The objective should not be to expand the universe of cross-border IORPs, largely because the obstacles are too great. The objective should be to look forward, not back, and to expand privately funded pension entitlements. Many Europeans have little or no private entitlement at all and addressing this issue requires new thinking. Given that the future is a DC future, the European Commission should introduce a framework for pan-European DC funds that can prove to be scalable. These could be sponsored by insurers, asset managers or potentially IORPs themselves. The overriding objective should be a scalable structure to ensure low costs for investors. The existing UCITS framework should be considered as it is already proven, and the additional scale that could be injected by extending its reach to pension savings should be beneficial for investors.

ConclusionEurope’s pension problems are significant and need to be addressed. A combination of policies focussed on increasing the retirement age and immigration will go some (small) way to limiting the impact of the demographic challenge. The tide of fertility cannot be reversed, and governments have little room to offer incentives for private saving. However, the Commission can be the architect of a new DC future and provide a structure that will in time overtake the current means of retirement provision. The debate on harmonisation of the IORPs framework continues, and EIOPA is to be commended for its focus on this most important welfare issue. n

1 http://www.ssc.upenn.edu/~hpkohler/papers/Low-fertility-in-Europe-final.pdf2 Draft Response to Call for Advice on the Review of Directive 2004/41/EC

A Common Framework

In 2003, the Institutions for Occupational Retirement

Provision Directive was adopted to create an internal

market for occupational retirement provision on a

European scale. The idea was that an employer in

one Member State could sponsor an IORP in another

Member State, and to allow an IORP in one Member

State to be sponsored by one or more employers

in different Member States. The Commission is

concerned that the take-up of IORPs has been

limited—there are only 84 cross-border IORPs (see

2011 Report on Market Developments, EIOPA, 14th

July 2011, para 2.1).

In addition, in its Green Paper, “Towards Adequate,

Sustainable and Safe Pension Systems” issued last

year, the Commission expressed its objectives as

follows:

• ToenableEUcitizenstobenefitfromgreater

pension choice at lower cost across the EU

• Toimprovethestabilityofpublicfinancesandthe

EU economy

24 J.P. Morgan thought / Winter 201224 J.P. Morgan thought / Winter 2012

The use of collateral is a time-tested mechanism for managing

credit risk. Although it has been used for many years as a

mitigant against potential counterparty default, the breakdown

or lack of proper procedures and controls between the two

counterparties could render this precaution ineffective and

sometimes detrimental. Appointing a collateral agent to

manage this important activity can have significant advantages.

O’Delle BurkeProduct Manager,

Collateral Management,

Asia-ex Japan & Australia

Independent Collateral Agents: The Interconnecting Link

An evolutionThe global financial crisis was a vivid reminder of the perils of counterparty default. Traditionally, credit risk management essentially falls into two categories—unsecured and secured risk. Unsecured risk is usually priced significantly more expensively due to the absence of collateral. Although unsecured credit is still available, post the financial crisis, such risk commands a substantially higher price. Pre-crisis, secured credit risk was primarily measured across two dimensions—the quality of counterparty and the quantity of collateral. Post-crisis, the quality of counterparties remains important but even more emphasis is now placed on the quality of collateral. A third dimension has also emerged which is the constant, diligent and frequent valuation and administration

of the collateral.

Collateral management is not new, but the importance and the discipline around the process was not given sufficient priority by some before the

financial crisis. As financial markets go through the process of post-crisis rebuilding, the use and efficient management of collateral is becoming more widely recognized as an integral tool for managing counterparty credit risk.

Furthermore, many new rules and regulations enacted across the world will require counterparties to clear

certain derivatives trades through central counterparties (CCPs). This is expected

to significantly impact not only the buy-side and sell-side market

players, but also CCPs themselves that are


now tasked with this critical risk management functionality with respect to collateral. CCPs’ core competency is not collateral management, but rather efficiency and execution. However, with this mandate, they are now confronted with this critical risk management function—an additional task of developing and implementing efficient and functional risk management infrastructures according to their markets. This is where collateral agents can play a significant role in providing infrastructural support to the CCPs. (Further information concerning OTC derivatives can be found on page 4.)

role of a collateral agentAs business models for collateral management are increasingly being analyzed and are evolving as a result, partnering with a collateral agent is becoming increasingly popular in closing the critical risk management gap. It is often the most timely and cost-efficient solution for an institution that expects its use of collateral to increase. Collateral agents can provide the technology, infrastructure and expertise that allow institutions to focus on their core activities, confident that their agent is tightly controlling the operational environment to efficiently manage process, cost and risk.

An agent’s fundamental responsibility is to administer the transaction and hold the assets. An independent third-party collateral agent will also need to undertake the role of facilitating collateral transfers for market participants, acting as the interconnecting link between market participants and CCPs. A collateral agent may provide solutions for the following:

ConclusionInstitutions are increasingly turning to collateral agents for assistance in mitigating their operational, counterparty and credit risks due to rapid and often complex regulatory changes. Clients can therefore benefit from an agent that has the infrastructure to support their enterprise-wide collateral management needs, including trading activity executed across multiple regions, and that possesses the local know-how and footprint to manage collateral both domestically and globally.

Collateral management will only become more central as the new wave of market priorities continues to gather momentum. Given the current risk-averse environment, the choice to employ a third party to serve a vital role in the collateralization process has become more imperative than ever. The right agent with the right infrastructure will be able to manage operational, settlement and market risks that stem from collateralization. n

Asset Servicing

safekeeping, dividend and interest payments, and corporate actions maintenance

eligibility testing

checking securities against pre-established eligibility, haircut and concentration limits

exposure Calculation

variation between initial strike price and daily spot price

Dispute resolution

work with counterparties to solve trade discrepancies

Margin Calls

coordination of request/delivery of additional collateral

Mark-to-Market

daily pricing and reference data updates

Cash reinvestment

streamline sweeps, interest accrual and distribution

recalls and Substitution

simultaneous replacement of existing collateral with other qualified assets

1 2 3 4 5 6 7 8


Program overviewSecurities lending is an investment overlay strategy that involves the temporary transfer of a security by its owner (the lender) to another investor or financial intermediary (the borrower) in a transaction that is collateralized with cash or securities. Securities lending is intended to complement investment strategies and allow investors the ability to monetize the intrinsic lending value of idle securities. The process of lending out these securities affords an investor the opportunity to produce alpha by generating income which can be used to increase portfolio returns or offset portfolio expenses with a manageable level of risk. Globally, securities lending provides critically needed liquidity in the financial markets,

supports a variety of trading strategies, facilitates trade settlements and supports general financing techniques.

In a traditional securities lending transaction, securities are lent short-term after provisions such as loan length, collateral type (cash or securities) and rebate rate or fee are agreed upon by the lender (or their lending agent) and the borrower. When transactions are collateralized with cash, a rebate rate will be negotiated between the lending agent and the borrower. This rebate rate, stated as an interest rate, represents the interest on the borrower’s cash collateral that the lender agrees to pay back at the termination of the loan. To generate a yield, the lender will invest the cash in short-term fixed income instruments

A best practice approach for entering a securities lending program requires

lenders to be able to clearly define the product, how it works, and the

associated risks in order to design a customized program that explicitly meets

the lender’s risk and return objectives. Having a thorough understanding of

securities lending is the first step in any program design.

A Best Practice Approach for Designing a Securities Lending Programeditor’s note: In our last issue we provided tips on oversight to benefit the participants of an existing securities lending program. (See “Securities Lending Defined,” Thought, Summer 2011.) For this issue we offer a blueprint with key guidelines to those who might be interested in designing or customizing a new lending program.

via a commingled fund or a separate account in order to achieve an interest rate above the rebate rate. The difference between the interest rate earned on the cash collateral and the rebate rate is the revenue (or spread) that is retained as earnings by the lender. In the case where the lender employs a lending agent, these earnings will be shared between the lender and the lending agent. Lenders should be aware of the market risk they assume with the investment of the cash collateral.

If securities (e.g., fixed income or equities) are accepted as collateral, or there is no cash to invest, a borrowing fee is charged. This fee (quoted as an interest rate) will be applied against the market value of the securities on-loan. If a lending agent is used, this fee is shared between the lender and the lending agent.

Managing program risks Securities lending, like all investment strategies, has a risk/reward trade-off. Historically, four types of risk have been associated with securities lending. Typically each of these can be managed through

implementing a variety of controls with the lending agent’s assistance. Counterparty/borrower risk can be mitigated by the lending agent through conducting extensive and continuous credit reviews, ensuring overcollateralization with daily mark-to-market, providing lenders with indemnification against borrower default, and a strong balance sheet to support the indemnification. Operational risk can be reduced by the lending agent through a robust operating framework, global scale and comprehensive understanding of transactional flows. Legal/contractual risk can be mitigated by using an industry standard securities lending agreement, compliance reporting and making certain the lending agent is utilizing a front-end compliance system. Cash collateral reinvestment risk rests solely with lenders and can be managed through appropriate program design and oversight from front-office or investment professionals. The cash collateral should be invested in securities that match a lender’s risk/return profile and be treated like any other short duration fixed income mandate.

Defining your approach Traditionally, the income earned from securities lending is added to the investment return associated with the lending portfolio(s). The lender’s portion of this income is utilized to lower the cost of various bank services (e.g., custody) provided to the lender. There are lenders who choose not to use this type of “bundled” approach and look for each bank service to be priced independently (i.e., “unbundled”) of the income earned from securities lending. Either approach, bundled or unbundled, should become part of the process for designing a securities lending program, requiring a lender to define their goals for participating in this type of investment strategy. A lender will need to decide if they are looking only to earn enough income to fully or partially offset bank-related fees, or if the main focus is to enhance portfolio returns. Each approach or goal will lead a lender to a different type of lending strategy risk profile. For example, if a lender is simply looking to offset some of their bank-related expenses, they might consider having strict lending and cash collateral reinvestment parameters, such as using only overnight government repo or accepting just securities collateral, thus limiting their lending opportunities. On the other hand, a lender seeking to produce additional alpha or income to reduce significant unfunded liabilities, considerably lower portfolio expenses and/or outperform competitors’

Securities lending benefits the global economy by:

• Providingliquidityinthefinancialmarkets

• Supportingavarietyoftradingstrategies

• Facilitatingtradesettlements• Supportinggeneralfinancing

techniques

There are four types of risks associated with securities lending:

• Counterparty/borrowerrisk• Operationalrisk• Legal/contractualrisk• Cashcollateralreinvestmentrisk



funds (e.g., index funds) may be willing to invest the cash collateral in a 2a-7 or money market type structure and take advantage of additional lending opportunities.

Selecting a program structure Working in tandem with the lending agent, lenders should design a program that achieves their goal and meets their risk/return objectives. A lender will need to consider four areas: program structure, loan type, parameters and collateral. Program structure refers to five types of lending distribution methods: agent discretionary, client-directed, auctions, exclusives and principal. In an agent discretionary program, a lender will utilize the lending agent to facilitate and negotiate loan transactions, evaluate borrower credit risk, provide collateral monitoring and/or cash collateral reinvestment and ongoing loan maintenance, and recordkeeping. A client-directed program allows lenders to operate their own lending platform using their custodian to facilitate loans and/or cash collateral reinvestment transactions. Generally speaking, auctions, exclusives or principal, are arrangements whereby a lender agrees to make their portfolio(s) or a portion thereof available for borrowing on an exclusive basis to a particular borrower for a pre-determined fee or price and period of time. Each program structure may be appropriate depending on a lender’s goals, portfolio composition and market conditions.

Loan types The second program design consideration is the types of loans (e.g., open, term, general collateral and specials) a lender is willing to engage in and the lending philosophy

(e.g., value or volume) utilized. Most loans are specified for an open period, which implies that the loan can be terminated at any time and the rebate rate or fee can be renegotiated. A term loan is for a specific period of time, generally at a fixed rebate rate or fee. General collateral loans are for securities that are not experiencing high borrowing demand and therefore produce lower earnings per loan due to higher rebate rates or lower borrowing fees. This approach, often described as volume lending, could necessitate a more aggressive cash collateral reinvestment strategy (e.g., money market) to allow for a greater level of reinvestment spread (i.e., yield earned above the federal funds rate) through the investment of cash collateral in higher yielding and longer duration securities. Volume lending will typically produce larger cash collateral balances which may lead to higher program earnings. A value approach would involve lending mostly “specials,” which are defined as securities with high borrowing demand as noted by very low and sometimes negative rebate rates or high fees paid by the borrower(s). This type of strategy produces a higher return per loan and would allow for more conservative cash collateral reinvestment guidelines (e.g., overnight repo).

Parameter specifications During the design and implementation phase, a lender will need to determine if any specific parameters should be enacted. One parameter, minimum spread, is defined as a specific level that sets a spread between the collateral investment rate and rebate, which needs to be achieved before a loan can take place. Another parameter, maximum on-loan, is used to specify the highest amount of a portfolio

Main goals for participating in a securities lending program:

• Higherportfolioreturns• Offsetbank-relatedfees

Lenders need to consider four areas in designing a customized securities lending program:

• Programstructure• Loantype• Parameters• Collateral

There are several types of loans that can be considered when designing a securities lending program. They include:

• Openperiodloan• Termloan• Generalcollateralloan• Specials


Joshua M. LavenderExecutive Director, Securities Lending

and/or a security that can be on-loan at any point in time. This parameter can be noted as an outright percentage of a portfolio or specific market value. The borrower limits parameter denotes the maximum amount (e.g., by market value or percentage) that a lender’s program can be on-loan to a particular borrower. Finally, a lender can establish specific account and security level restrictions. For example, a lender may choose to make a certain cusip ineligible for lending. Each of these parameters allows a lender flexibility to design and implement a securities lending program that explicitly meets their objectives.

Options for collateral The final step a lender takes in designing their securities lending program deals with collateral options (e.g., cash and/or securities). Lenders who choose to accept only securities as collateral should be aware that lending opportunities may be reduced, and they will need to decide which types of securities are acceptable from a risk standpoint. When cash collateral is accepted by the lender, they may have the option of selecting from a variety of cash investment vehicles. Such options include a dedicated separate account, a commingled fund, an external (i.e., to the lending agent) investment vehicle and a “self-invest” model, whereby the lender invests the cash. A separately managed account allows a lender to customize their cash collateral reinvestment program to meet their unique risk and return requirements, allowing for increased transparency and control. A commingled fund pools lenders together according to a common investment strategy. With an external investment vehicle, a lender may already have positive experience with a specific fund

or investment manager and therefore select this option. A lender who feels that managing short-term cash is a core competency of their firm may choose to utilize the self-invest model. This part of the securities lending design process requires that the lender fully understands and is comfortable with the cash collateral reinvestment vehicle’s investment philosophy (e.g., capital preservation, income) and guidelines (e.g., liquidity level, duration, credit quality, security types and sector). Choosing the appropriate cash collateral reinvestment vehicle can depend on a variety of factors such as lending program size, liquidity requirements, control/ownership level, desire to influence investment decisions, transparency level and ability to match risk/return tolerance.

Summary Securities lending has been an integral part of the financial markets for over 75 years and continues to provide valuable opportunities for investors to earn additional income or alpha within a risk-controlled environment. This investment strategy enables lenders to enhance portfolio returns and offset portfolio expenses. The best practice approach to designing a securities lending program should encompass a thorough understanding of the product, lending and collateral options and the lender’s individual goals and risk/return objectives. n

There are several types of parameters that lenders can enact in implementing their securities lending program. They include:

• Minimumspread• Maximumon-loan• Specificaccountandsecuritylevel

restrictions

Options for investing cash collateral include:

• Dedicatedseparateaccount• Commingledfund• Externalinvestmentvehicle• Self-investedaccount

Choosing the appropriate cash collateral reinvestment vehicle depends on:

• Lendingprogramsize• Liquidityrequirements• Control/ownershiplevel• Desiretoinfluenceinvestment

decisions• Transparencylevel• Abilitytomatchrisk/return

tolerance

Working in tandem with the lending agent, lenders

should design a program that achieves their goal and

meets their risk/return objectives.


One of the key components to risk mitigation in any securities lending program is collateral. In

managing a securities lending program, both the collateral, including the haircut and marking to

market the loans and collateral on a daily basis, as well as the combination of counterparty quality

and collateral mix, are highly important. But what is the current market trend for collateral?

The Benefits of Collateral Diversification in a Securities Lending Program

Notwithstanding the market turmoil and issues raised by the Lehman default and ongoing credit crisis, we have seen a continued recovery in loan volumes over the past three years. Demand, however, remains suppressed despite a healthy appetite from beneficial owners to lend securities. (In fact, we have seen a positive trend in new beneficial owners lending their securities for the first time.) This lack of demand is in part driven by over-supply in the fixed income market, lower hedge fund activity, deleverage in the equities market and a changing and uncertain regulatory

environment that is impacting all market participants. Regulation, in particular, is really changing and driving the way in which borrowers manage their balance sheets and capital, which in turn is driving the cost of borrowing and the manner and way in which borrowers collateralize loans

from beneficial owners. Basel III, Dodd-Frank, EMIR and FSA liquidity rules are just a few of the specific regulations that are impacting the borrower side of the industry. This is manifesting itself in the ways we see different borrowers prefer to collateralize loans. This, in turn, is critical to understanding the forces that are driving demand for collateral itself as well as securities to

cover various trading strategies.

If we look at J.P. Morgan’s overall program as an example (see chart), cash collateral now accounts for approximately 50% of all collateral. However, since 2008 the largest growth has been in equities, while overall there is a more balanced breakdown of the types of collateral we have been receiving.

As noted above, this has typically been driven by the individual funding needs of borrowers. Additionally, we have seen many borrowers undertake internal collateral/funding optimisation which has led those borrowers to display contrasting preferences as to the type of collateral they wish to provide. This is in contrast to the market several years ago, where we tended to see market shifts in waves with either cash or fixed income being more or less favourable. Today there is no such consistent shift—each dealer has clear and distinct preferences to the type and term of collateral they want to deliver. It is possible that for the same transaction, in terms of collateral and duration of the loan, four different dealers will have four different requirements. Term loans versus cash collateral, open loans versus equity collateral, or term loans versus fixed income collateral, are just a few examples of the different types of current loan and collateral structures.

The impact of these trends can be quite significant for beneficial owners. Balances can be built, or lost, simply because of a borrower’s collateral requirements. As we have stated previously, while collateral is a prime risk mitigant, a beneficial owner who is able to accept a broad range of collateral types will benefit significantly in terms of balances and revenues.

Collateral diversificationThe dynamics between the correlation of the underlying securities on loan and acceptable collateral is fundamental to understanding that collateral flexibility does not imply increased risk. On the contrary, the benefits of diversification have long been recognised;



governance requirements that enable them to broaden the scope of acceptable collateral.

Historically, the oversight of the securities lending program had been carried out as a back office function, but this has progressed to a front office and risk and compliance function. Transparency of collateral parameters has clearly been an integral part of beneficial owners’ additional oversight of the program with the following reports typically being interrogated:

• Daily Securities Collateral Detail—detailing the security collateral allocated to the lender’s loans

• Investment Daily Accounts Statement—detailing the lending client’s collateral investments with key features, including settled and pending investments, ratings and maturities, including a summary providing subtotals for various categories with weighted yields

• Investment Mark-to-Market—providing the latest market value of investments within the lender’s cash collateral investment portfolio

• Reverse Repurchase Collateral Detail—providing underlying collateral on the repo buy counterparty

As noted, collateral flexibility ensures diversification of collateral and borrowers while aiding optimum performance. The securities collateral schedule focuses on high quality, diversification and concentration of non-cash collateral. Securities collateral includes U.S. government

Paul wilson International Head of Financing and Markets Products, Technical Client Management and Sales

this holds true for a portfolio of collateral as much as it does for a portfolio of investments. Risk can be reduced by diversifying collateral to several asset classes, differing or by higher margin levels. Equities are a good example, whereby the acceptance of correlated collateral, for example equities against equity collateral, enables beneficial owners to benefit from increased utilisations and spreads. Borrowers who are actively trading in equities will pay a premium to use their own long positions as collateral against borrowed positions and benefit from higher haircuts (7% to 10%) and highly liquid and easily priced collateral.

Accepting these concepts is one thing, but diversification in collateral requires more resources and technology for two reasons. First, diversification requires appropriate reporting about the nature and whereabouts of the collateral that is being accepted, and second, diversification of collateral needs to be monitored, marked accessed, liquidated and realized in a rapid time frame if required. The Lehman default proved that securities lending processes around these events actually worked; the new landscape and the rise of collateral trading techniques to optimise balance sheet usage has renewed the challenge to ensure process, procedure, documentation and controls are sufficiently robust.

transparent reportingWithout transparent reporting, beneficial owners are limited in their ability to satisfy their internal due diligence and

2008 CASH

FIxED InCOME

EQUITIES

43.5%

53.6%

2.9%

2009 CASH

FIxED InCOME

EQUITIES

59.8%

32.7%

7.5%

2010 CASH

FIxED InCOME

EQUITIES

40%

50%

10%

J.P. Morgan Securities Lending Collateral


and agency debt in addition to minimum AA- rated eurozone, OECD and UK government debt. Beneficial owners also have the ability to add equity collateral to their schedules where appropriate.

In the same way that borrowers have disparate collateral preferences, so too do lenders. The trend has been for a greater desire for customised collateral schedules, particularly in the central bank, sovereign wealth and insurance sectors. Traditionally, agency programs have adopted pooled collateral techniques to maximize efficiencies and the scalability of their models. This still holds true, but in today’s environment there is a clear need to offer customised solutions for specific trade types.

the tri-party collateral agentThese forces have consequently fed the demand for a tri-party collateral agent who can manage, clear and rehypothecate collateral among many different counterparties in the market. A tri-party collateral agent, amongst other services, can hold securities (security, safekeeping and reporting), mark-to-market, optimise the use of long inventory, test for collateral eligibility and issue margin calls.

Because the tri-party collateral agent acts as a centralized exchange between lenders and borrowers, the benefits include but are not limited to:

• Reduced costs for both lender and borrower as back office and IT are effectively outsourced

• Lender and borrower can invest in core business instead of collateral management

• Scalability and ability to trade at higher volume more frequently

• Diversification in acceptable collateral as tri-party agents handle a much wider variety of collateral instruments than would typically be the case in a bilateral arrangement

• Standardization; collateral agreements and protocols are typically dealt within industry standard agreements across the whole spectrum of collateral givers and receivers, helping to eliminate inefficiencies and uncertainties that can exist due to variances in legal interpretations

The use of an organization with the depth of resource to invest in efficient collateral management is a prerequisite to positioning a lending program to enable its optimum performance in today’s securities lending and collateral trading market.

J.P. Morgan undertakes strenuous review of acceptable collateral, conducting stress tests and analysis and applying appropriate haircuts based upon eligibility, asset class, liquidity, diversification and currency of collateral. In order to maintain greater control, given increased complexitities of collateral management, we have fully integrated our securities lending activity with J.P. Morgan’s market leading tri-party collateral management offering to provide our clients greater flexibility and increased control. n

tailored GuidelinesJ.P. Morgan has always offered segregated cash collateral investment guidelines which allow the lender to tailor the guidelines according to their risk parameters and appetite. This flexibility has allowed lenders to tailor their investment guidelines according to a changing environment, for example, amending maximum tenor, quality guidelines, products and concentration guidelines.

J.P. Morgan reporting toolsJ.P. Morgan provides a wide breadth of client reporting through Views Portfolio Reporting, with key functionality, including report customisation, data drill-through, flexible output formats and alternative delivery options (e-mail, auto-save, file ftp, auto print). The reporting function also provides a scheduler feature that allows data and time dependant reporting events to be created and automatically e-mailed to recipients.

J.P. Morgan’s Securities Lending Dashboard has been introduced to allow beneficial owners to view all key reporting parameters and information in a single customisable view.

The continued investment in reporting enhancements for beneficial owners has been important in assisting them with evolving compliance checks in a changing market environment.

This interest is not surprising, given the amount of gold that is held privately and by sovereigns. Approximately 28% of gold reserves are held privately, with the remainder being held by sovereigns, with the U.S., Germany and the IMF holding the most significant proportions.1

Optimizing gold holdingsFacing diminished liquidity over the past few years, institutions have been searching for ways to optimize all assets to their greatest effect. Financing trends seek to fully utilize all asset classes, including non-standard securities such as exchange-traded funds (ETFs), Middle East eurobonds and fund units. Following the financial crisis, many institutions chose gold as a hedge against inflation, to support their trading strategies, or to maintain strong capital reserves. The emergence of exchange-traded funds and exchange-traded commodities, backed by bullion, also drove surging demand for physical gold. According to Peter Smith, head of J.P. Morgan’s gold vaulting service, “There is growing interest from ETFs and other fund institutions, as well as from corporates, to store precious metals.”

While gold is undeniably valuable, historically it has also been a relatively immobile asset. As

During the past several years, the price of gold has

hit new highs and set new records on a regular basis,

causing institutions to look for ways to use the highly

valued asset to best advantage.


Golden opportunities

J.P. Morgan recently integrated its gold vaulting service in London with its tri-party collateral agency service.

• J.P. Morgan operates one of the two largest commercial gold vaults in London (one of only six in the City) and is a member of the London gold clearing system.

• J.P. Morgan is also one of the few truly global providers of collateral management services. As collateral agent, J.P. Morgan works with two parties that have an established collateralized lending or financing arrangement.

Linking these two services allows for the use of gold as collateral in tri-party secured financing transactions. John Rivett notes that this gives institutions a new avenue to mobilize their physical collateral inventory alongside their securities inventory and to monetize their gold positions in an operationally efficient manner. J.P. Morgan clients have several options:

• Unallocated gold custodied with J.P. Morgan can be used immediately as collateral, once the appropriate documentation is completed.

• Gold that meets the London Good Delivery unallocated gold standard but which is held in another London gold vault can be delivered to J.P. Morgan with J.P. Morgan as custodian. As noted earlier, use of the London clearing system simplifies this process for unallocated gold. In fact, the six

clearing firms form a company called London Precious Metals Clearing Ltd to streamline this process, which in many cases is a simple book entry.

• Allocated gold can be converted by most bullion banks/agents to unallocated gold and can then be used within the collateral program.

• Gold held outside of London can be transferred to J.P. Morgan’s London vault either directly or via one of the other London gold vaults using the process described above.

Once the gold is delivered, it is reflected in the client’s books and records and can be used as collateral in a variety of transactions. Since unallocated gold is being used, it can be apportioned in quantities smaller than a gold bar, increasing its flexibility as a collateral asset.

According to John Rivett, “We continue to uncover ways to use gold as collateral. Today, we’re talking about stock loan escrow and tri-party repo transactions, but nearly every client has other ideas they wish to discuss.” Gold could be used to satisfy initial margin for clearing members subject to Dodd-Frank regulations, for example, joining other high grade assets such as cash or government securities to satisfy the initial margin demands of central counterparties. Rivett notes that J.P. Morgan is helping clients imagine how gold might fit into their trading or collateralization strategies and how they could monetize this asset class.

it became a proportionately larger share of the balance sheet, however, the question of how best to monetize gold became increasingly common.

Using gold to diversify the collateral pool Gold has many characteristics that make it appealing as collateral. It is liquid, high quality, and traded and priced globally. As counterparties seek to diversify their collateral pools and stringently review their collateral options, gold takes its place amidst other high grade collateral such as government securities and cash. Gold has the added attraction for collateral takers of being “right way collateral,” which means that in times of crisis, its price is generally expected to rise, thus providing added protection and diversification to traditional forms of non-cash collateral such as fixed income or equities. According to John Rivett, global business executive for collateral management, “It would be difficult to find a more stable and secure asset than gold. Gold shines when there’s a flight to quality: it runs counter to the market in valuation whenever there’s a credit crunch or fear of contagion.”

Understanding the global gold marketCommercial gold vaults exist in New York, Zurich, Singapore, Dubai and other locations. However, London has long been the hub of the world’s 24-hour global gold market as it is perfectly situated from a time zone perspective to serve as the center of trading and liquidity. In fact, according to the London Bullion Market Association, “Most global over-the-counter gold and silver trading is cleared through the London Bullion Market clearing system, with deals between parties throughout the world settled and cleared in London.”2

The characteristics of the London market uniquely support the use of gold as collateral by ensuring:

• Quality and liquidity: “London Good Delivery” sets the standard for gold quality. Rigorous specifications as to size and purity ensure that each London Good Delivery gold bar meets pre-set standards with little to no variation between one bar and the next. This consistency ensures that counterparties will

new ways to Put Gold to work



receive gold of an expected quality (99.5% fine), which allows the metal to be easily transferred between members of the London Bullion Market. Ultimately, this facilitates trading and market liquidity—both desirable attributes for collateral.

• Flexibility: The London gold market uses both unallocated and allocated gold. In layman’s terms, allocated gold specifically identifies each gold bar with a specific owner. Allocated gold is essentially held in separate accounts; it cannot be pooled with gold from others to satisfy obligations. In contrast, unallocated gold is held in a general pool by the bullion dealer and the customer has a general entitlement to the metal, but not to a specific gold bar. The LMBA states that unallocated gold “is the most convenient, cheapest and most commonly used method of holding the metal.”2

In practical terms, unallocated gold is comparable to putting dollars, pounds or euros into the bank. Once deposited, the money becomes fungible—you can withdraw the same amount of money you put in, but you will not receive back the same exact bills that you deposited. The use of unallocated gold allows for amounts smaller than a gold bar to be used as collateral between counterparties—a significant benefit to a collateral program given that a London Good Delivery bar weighs 438.9 ounces, and gold is currently trading for over US$1,700 per ounce.3

• Transparency: Readily available price information promotes market transparency and aids in daily mark-

U.S. Dollar London Gold Fix (PM) RatesOCTOBER 1991 TO OCTOBER 2011Source: U.S. Dollar London Gold Fix (PM)

to-market and margin calculations. Gold is priced by the market twice daily (morning and afternoon) and widely reported by both the financial press and data vendors. Use of a predictable daily price fix point allows counterparties to mitigate their daily exposure and set haircuts to manage ongoing price fluctuations. The afternoon U.S. Dollar London Gold Fix is viewed by market participants as the appropriate way to mark gold given daily price fluctuations and increasing values.

• Ease of transfer: The London Bullion Market clears daily using paper transfers that evidence the unallocated gold held between members. This allows them to simply and efficiently settle mutual trades and transfers to/from third parties while mitigating the costs and risks associated with physical movement of bullion. The use of paper transfers and unallocated gold facilitate easy transfers between counterparties when needed.

The unique characteristics of the London gold market made it the ideal starting point for using gold as collateral, but opportunities in other markets are currently being assessed. Additionally, as J.P. Morgan works with clients seeking to optimize all of their assets, it is also evaluating the potential for using other metals (such as copper, silver or platinum) or different commodities as collateral. n

1 World Gold Council (end 2008)2 www.lmba.org.uk 3 www.gold.org, November 8, 2011

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Gold has many characteristics that make it

appealing as collateral. It is liquid, high quality,

and traded and priced globally.

From Idea to Implementation: U.S. Tri-Party Repo Market Reforms



Shifting the unwind to 3:30 p.m. without affecting intraday market liquidity was no easy task, according to Mathieson. For J.P. Morgan, it required the development of innovative technology that would give dealers access to their securities even while they remained “locked up” in tri-party shells. “We were already working on Auto Substitution when the market reforms were first discussed, because it was clear to us that the current market dynamics would have to change,” Mathieson comments. “As it turns out, Auto Substitution was the key to our clients’ ability to smoothly transition to the later unwind.” Auto Substitution substitutes eligible securities or cash for assets held in tri-party repos, giving dealers access to their collateral throughout the trading day to foster market liquidity.

Mathieson notes that it took more than innovative technology to move the timing of the daily unwind. “We spent 18 months carefully reviewing our operations and service models to ensure that we’d be ready to support the compressed unwind cycle.” When the daily unwind moved to 3:30 p.m. on August 22, J.P. Morgan had successfully cut its processing time in half—returning cash to investors while allowing dealers to promptly reallocate their collateral.

The final change to the daily unwind will take place when GCF (rehypothecated collateral) moves to 3:30 p.m., bringing all market unwind practices into full alignment.

Using a model different from other reform initiatives, these changes have been driven by a private-sector task force formed under the auspices of the Federal Reserve Bank of New York. The task force is a cross-section of industry participants guided by the Fed. It is self-directed and self-governing, with a goal of structuring reforms that are actionable, commercially reasonable and effective for all parties. According to Kelly Mathieson, business executive for global custody and clearing at J.P. Morgan, “In a relatively short period of time given the tenor and size of this market—less than two years—we’ve seen a number of the proposed reforms move from idea to implementation.”

Changes to the daily unwindA mere 13 months after the Task Force for Market Infrastructure Reform first announced its plans to alter how risk was managed in these markets, the first movement of the daily unwind took place. Over the course of three dates in June, July and August 2011, the daily unwind shifted gradually from start of day to 3:30 p.m. This controlled process, agreed to by all market participants, dramatically reduced the amount and duration of credit extended by the clearing banks.

The last six months of 2011

wrought significant change in

the U.S. tri-party repo markets,

fundamentally changing how

the markets operate, the role

played by the clearing banks,

and the levels of transparency

for dealers and cash investors.

What Is the Daily Unwind?

Historically, by providing credit to dealers, the clearing banks made cash available

to cash investors and returned securities to the dealers each morning, even

though the repo had not yet matured. This process, known as the “daily unwind,”

enabled dealers to access their securities during the trading day. It also created a

heavy reliance on intraday credit extended by the clearing banks.


Greater transparency for cash investorsImproving market transparency is another key task force goal. In particular, the task force wanted cash investors to be more involved—to have greater access to information and to have the ability to confirm trades, which previously had been instructed solely by the dealer.

Between the end of August and early October, three-way trade confirmation was implemented. This required cash investors to confirm that the trade details submitted by the dealers were accurate. Transaction instructions had to match on 13 mandatory fields, and any unmatched transaction would not be processed.

Implementing this change required active participation from the entire tri-party repo community, as amendments to the legal agreements needed to be signed by all parties; the dealers needed to provide additional transaction details; the clearing banks needed to give cash investors the information and tools necessary to see their activities; and the cash investors needed to actively confirm the transactions submitted by the dealers.

J.P. Morgan accomplished these tasks with a new reporting platform and trade confirmation engine for cash investors—Repo AccessSM. This system was rolled out five months before the trade confirmation deadline, giving cash investors ample time to familiarize themselves with the reporting tools and the new affirmation process.

August 29 was the first full day of trade matching. Despite the implementation of a grace period by the task force, on that day 30% of all U.S. tri-party repos booked utilized J.P. Morgan’s proprietary Repo Access functionality. When the grace period ended on October 4, 99% of trades processed through J.P. Morgan, by value, were confirmed by both counterparties. J.P. Morgan also accepted trade instructions and affirmation via a variety of different messaging types, including SWIFT, and via third-party vendor

services. According to Mathieson, this clearly differentiated J.P. Morgan’s offering from that of the competition. “It sent a clear signal to the market that J.P. Morgan has made smart investments to improve our product offering and was ready ahead of schedule.”

improved risk management tools2011 reforms conclude with the development of collateral simulation tools that would allow the clearing bank to assess different scenarios in the event of a market crisis. Developed for selective use, these tools further improve market transparency for both the clearing bank and the regulators.

A look ahead to 2012According to Mathieson, 2012 will bring further reforms to the U.S. tri-party repo markets: “Right now, task force members are actively discussing measures that will provide dealers with additional financing options and facilitate a more conservative and planned approach to liquidity management.” While the details have yet to be finalized, Mathieson notes that the process of active debate among all market participants has, thus far, resulted in reforms that are not only agreed upon, but implemented. “One thing is certain,” she notes, “we can expect that 2012 will be every bit as transformational as 2011 has been.”

As one of only two U.S. clearing banks for U.S. federal and government securities, J.P. Morgan has been an active participant in the task force since its inception and serves as co-chair of the Operational Arrangements Working Group. n

2012 will bring

further reforms to

the U.S. tri-party

repo markets.


editor Michael Normandy

Contributors Erika ArevuoSeth Baer-HarshaJessica ConradÓrla KellyMalar ManoharanBeth MeadAdele SmallRebecca StaimanPeter van DijkSharon Weise-Nesbeth

Help us to improve Thought. Please visit jpmorgan.com/wss/thoughtsurvey and tell us what you like and don’t like about the publication. We appreciate and value your input. Thank you.

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About JPMorgan Chase & Co.

JPMorgan Chase & Co. (NYSE: JPM) is a leading global financial services firm with assets of $2.3 trillion and operations in more than 60 countries. The firm is a leader in investment banking, financial services for consumers, small-business and commercial banking, financial transaction processing, asset management and private equity. A component of the Dow Jones Industrial Average, JPMorgan Chase & Co. serves millions of consumers in the United States and many of the world’s most prominent corporate, institutional and government clients under its J.P. Morgan and Chase brands. Information about JPMorgan Chase & Co. is available at www.jpmorganchase.com.

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As markets fluctuate and evolve, our global

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