Middle East
The Middle East has been suffering a torrid time of late. The Arab spring saw rulers forced from power in Tunisia, Egypt, Libya and Yemen while civil uprisings erupted in Bahrain and Syria. Prior to 2011, and despite a history of political strife, the Middle East & North Africa (MENA) has not traditionally been perceived by foreign investors as a region particularly prone to political risk.

The region is home to the world’s largest supply of crude oil and as it becomes more financially sophisticated it is starting to realise its potential. Although short selling already takes place on the Abu Dhabi Securities Exchange (ADX) and the Dubai Financial Market (DFM) it is unregulated so there is a risk if contracts are broken, parties won’t be able to sue. In fact, the Emirates Securities and Commodities Authority (ESCA) spoke out against short selling last year, saying “short-selling operations are inconsistent with the spirit of these [established] regulations”.

Upcoming regulations

However, regulations concerning short selling and securities lending are imminent. The UAE Securities and Commodities Authority (SCA) published draft regulations at the end of last year stipulating that short selling of securities listed on the UAE markets will be permitted. However, as we head into the middle of 2012, it may seem strange that these regulations have yet to be ratified. David Lewis, senior vice president at Sungard, offers some explanation.

“Part of the delay to the regulations is because they are rightly fastidious about consulting. There has been lots of consultation with local stakeholders,” he says.

There could be another reason for the delays, which concern how the market is currently working. One well-placed source in the Middle East thinks that the dominance of local investors in the market may be an issue.
“There has been an uptake in volumes with local investors coming into the market. It would be risky to introduce something that would deter local investors. Regulators in the market don’t want to deter local investors. Anything that would put them off won’t be supported by the market,” he says.

Another possible reason for the perceived reticence in introducing the regulations could be Islamic finance and complying with Sharia law. “Islamic finance is part of [the reason for delay], you shouldn’t be able to sell something you don’t own. They are very nervous to introduce something were you gain from markets going down,” said one player.

However, he said that an Islamic repo is being developed based on an underlying Sukuk that would negate any conflict with Sharia law. Others aren’t convinced that there is such an issue with Islamic finance, rather a misunderstanding of the economics. “In line with some observers’ incorrect view that short selling is potentially harmful to portfolio values, the activity falls foul of the principle banning “unjust deeds”, as interpreted by some Islamic scholars. Short selling brings transparency and liquidity to the market. Multiple studies have shown statistically that short selling doesn’t harm the market,” says Lewis.

Richard Street, head of securities and fund services in Middle-East at Citi, believes the regulations are not simply about legitimising short selling but also building on existing improvements to the market.

“Stock lending regulations stop well short of endorsing short selling, they are designed to facilitate the failed management process, hence perfecting the recently introduced delivery versus payment (DVP) model,” he says.

With these regulations in place the UAE and Qatar might finally earn their upgrade from frontier market to emerging market from MSCI. However, they failed to earn this upgrade in February.

MSCI Upgrade?

At the moment, the UAE and Qatar are classified as ‘frontier markets’. Georges Elhedery, head of global markets in MENA at HSBC explains why the MSCI classification is important.

“It remains to be seen whether the UAE and Qatar will form part of the MSCI Emerging Markets Index this year. This certainly isn’t a foregone conclusion - but if successful, this would lead to more international money coming into the region as global emerging markets funds will flow towards these important markets. At present, these markets are classified as ‘frontier’ and very little institutional money follows the MSCI Frontier indices,” he says.

As two of the criteria MSCI use to classify markets includes securities lending and short selling, some view that the impetus behind the upcoming regulations is to secure the upgrade. “These countries aren’t promoting sec lending and short selling because they necessarily believe it’s a great idea, but they do understand that such infrastructural developments are required to achieve the upgrade. The much bigger picture is the upgrade, which opens up the market for investment,” says Lewis.

Street agrees, saying that the regulations are being done on behalf of the market to secure the upgrade, although he doesn’t think that an upgrade will immediately transform the market.
“The MSCI upgrade might help to mature the market but gaining the emerging market status won’t change the securities lending and borrowing rules overnight,” he says.

MSCI also argues that markets in the Middle East haven’t implemented the Delivery vs Payment (DvP) system effectively. The main problem concerns failed trades, where a forced sale of assets without the owner’s consent is still possible. Street sees this as the major barrier to an MSCI upgrade.

“The regulations are being crafted to perfect the DvP model with a goal to secure the upgrade to emerging market status. MSCI wants a DvP environment; it is not demanding short selling,” he says.

One other major sticking point concerning the possible upgrade is the issue of foreign ownership. The current limits on foreign ownership in markets such as Qatar, where the limit stands at 25 per cent, will have to be addressed before an upgrade is given.

Current market

All the markets in the Middle East use a beneficial ownership system, securities are held in the name of the ultimate investor and execution on exchange is undertaken by a member of the market - a local broker. Brokers can’t take a proprietary position in the market.

The markets across the Middle East are dominated by local retail investors with Saudi Arabia being the largest market in the region. Currently Tadawal, the Saudi Securities market, is only directly accessible to Gulf Co-operation Council investors.

“Non GCC investors can only obtain Saudi exposure through swaps and other synthetic products. Saudi is currently reviewing this foreign investor rule. The region remains hopeful that the Saudi market will be opened for foreign investors to participate directly in the near future,” says Street.

Recently there were suggestions of insider trading at the ADX because hours before an announcement that two of the emirate’s biggest real estate developers would merge into a $15 billion property titan, the shares of Aldar Properties and Sorouh rose in tandem by 7.9 per cent to Dh1.22 (33 cents) each.

The CEO of Abu Dhabi Securities Exchange, Rashe Al Baloushi, stated that the ADX carries out daily routine checks on all share trading activities and can detect any instance of share-trading violations.

One industry insider says: “Custody is now regulated actively. Kuwait and the UAE will suspend stocks if there is failure to report.” There is very solid management of the markets one motivation being to attract foreign investment.

Regulate it and they will come

The MSCI Emerging Market index is used as a benchmark by fund managers, and can result in billions of dollars worth of extra liquidity for markets that are reclassified. However, as Lewis points out, “all the usual suspects” are already in the Middle East and have large clients. He says that national players will look to become a regional presence and hope to eventually become an international force.

EFG Hermes are a dominant local broker in the region however, other domestic players may need assistance from established global names.

“Domestic players won’t necessarily have the experience or infrastructure and will look to partner with global players. As securities lending starts you might find names becoming active that are familiar out there but not here [in London],” says Lewis.

According to Phil Gandier, head of transaction advisory services at Ernst & Young MENA, there are still regulatory issues that deter foreign investment in the region. “The regulations are a bit opaque,” he says. ”Governments could change laws quickly. You would have a broad kind of principle as a law, but detailed regulations weren’t there. It was up to the employees working at the applicable regulatory body at the time to decide how they wanted to implement or interpret that law.”

It seems that once the Middle East clarifies its regulations and eventually gains the MSCI upgrade, there are almost limitless possibilities for the region. If the area can have a prolonged period of political stability, securities lending will grow with an influx of international players.
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