Long touted as a means to deepen Middle East stock markets and attract more foreign money, securities lending and borrowing remains in its infancy in the region. Yet behind the scenes, brokers and asset managers say significant steps are being taken to realise these ambitions.
Such plans are part of a broader effort to put the Gulf on international investors’ radar. Influential index compiler MSCI upgraded Qatar and the United Arab Emirates to emerging market status in 2014 after the two countries’ bourses and regulators undertook myriad reforms that were prerequisites to achieve such a classification. These included changing the settlement process and making stocks more easily accessible to foreign investors.
Saudi Arabia and Kuwait completed similar modifications to achieve the same – Saudi joined MSCI’s Emerging Market Index in May 2019, while Kuwait will become a member next year. The four Gulf countries are now also all part of the FTSE Russell Emerging Market Index. Egypt is in both benchmarks too.
Yet for all these improvements, Middle East bourses remain largely long-only markets, with securities borrowing and lending and short selling little used despite efforts to create the necessary infrastructure and regulations to permit such practices.
“The Middle East is strange in that it’s home to some of the world’s largest sovereign wealth funds, who are very experienced international investors and use securities borrowing and lending in the markets in which they invest, yet their local markets are still relatively underdeveloped,” says Andrew Dyson, chief executive of the International Securities Lending Association (ISLA).
The influx of passive, and to a lesser extent, active foreign funds in the wake of the emerging market upgrades has steadily lessened the influence of still-dominant retail traders.
“Retail investor activity will continue to decline in significance,” says Ibrahim Masood, chief investment officer at Aventicum Capital Management Qatar, whose major shareholders are Qatar Investment Authority and Credit Suisse. “Nevertheless, introducing short selling into markets where retail investors account for 70-80% of trading will require very robust regulatory frameworks – what are the margin requirements, how much collateral do you need, etcetera.”
Lacklustre trading remains a problem on Gulf bourses as tougher regulations deter speculators, while retail investors are still scarred by the steep declines from the late 2000s onwards – as of August 11, Saudi’s bourse was trading 59% below its record high, while Dubai is down by more than half from its all-time peak. Abu Dhabi, however, hit a record high in April 2019.
“To make these markets really work you have to have good liquidity - the exchanges are alive to these issues. There’s an understanding that if you want to have a broad capital market structure you need liquidity, and a lot of liquidity comes from securities lending-type activity,” says ISLA’s Dyson.
“It’s not just covering short positions. Lending also facilitates market making – if you’re going to have a good two-way market, it’s vital that market makers can trade knowing they’ve got access to securities lending pools if they have to fulfil a sale where they didn’t have a security in their inventory.”
Securities borrowing and lending has been permitted on the Dubai Financial Market (DFM) since June 2014, with short-selling regulations introduced in January 2018. Short selling is restricted to stocks that meet various criteria including a minimum trading volume and for at least 50% of a company’s shares to be free float. As of July 2019, just 11 listed DFM companies were eligible. These include Emaar Properties, Dubai Islamic Bank, and construction firm Arabtec Holding.
A DFM spokeswoman says securities borrowing and lending was “still very minimal because regulated short selling has not taken off yet”, also noting that no regulated short sales transactions had yet been completed through the exchange.
“In terms of stock borrowing and lending, there are ways that it can happen. One is the regulated way, with a few companies in the UAE licensed to provide such services,” says Mohammed Yasin, chief strategy officer at Abu Dhabi’s Al Dhabi Capital. “But the inventory they have isn’t substantial or much used. The over-the-counter (OTC) market for stock borrowing and lending precedes the regulations and is much larger and more established. It’s a more efficient way for these institutions to lend and borrow stocks.”
OTC borrowing and lending is unregulated which brokers prefer because it enables them to retain control of these assets.
“If they do it via an exchange, they would need separate custodian accounts and there’s certain reporting standards, which adds cost and makes it less efficient,” says Yasin. “I don’t see the two paths converging. I doubt the regulators have the appetite to push OTC providers to do it on the exchanges.”
The Securities and Commodities Authority (SCA), which regulates the DFM and Abu Dhabi Exchange (ADX), published requirements for securities borrowing and lending in 2012, restricting short selling to market makers.
In 2015, National Bank of Abu Dhabi – now part of First Abu Dhabi following its merger with First Gulf Bank – became the first UAE institution to be licensed to conduct securities borrowing and lending.
“Regulated stock borrowing and lending will be done more by individual investors - retail and high net worth - but the bigger inventory will continue to be OTC,” says Yasin.
Currently, investors wanting to do regulated securities lending in the UAE must have a short-selling account into which securities they borrow are transferred before they can then sell them. “This isn’t the most efficient or practical method,” says Aventicum’s Masood.
Having permitted foreigners to directly own Saudi listed shares in 2015, the kingdom has rapidly sought to open up its financial markets to international investors.
As of the end of July, over 1,305 qualified foreign investors (QFIs) had been approved to trade Saudi stocks, the kingdom’s bourse told Global Investor. Foreigners were net buyers of more than 51 billion riyals of Saudi shares in the first four months of 2019, while their presence could become even greater after Saudi in June removed a cap on strategic foreign investors that could lead to local companies becoming majority foreign-owned.
Meanwhile, Saudi’s fledgling Securities Clearing Center Company (Muqassa) will launch operations once it receives all the necessary regulatory approvals, which are expected before the end of 2019. It will first clear index futures contracts before providing clearing for equities, sukuk, bonds, ETFs and REITs next year. Muqassa is slated to start clearing derivatives in 2021.
“Currently you can’t do post-trade allocations from an omnibus account. These sorts of things need to be implemented for short selling to become practical.”
Yet he also describes Saudi as “a matter of time” before the required reforms are implemented.
“That, in turn, will probably spur other Gulf markets – particularly Dubai, Kuwait and possibly Qatar – to implement the necessary infrastructure to do likewise,” says Masood.
“It may appear that the region hasn’t made enough progress, but behind the scenes there’s a lot of work being done. Now, the bits that are outstanding aren’t so complex or difficult to achieve.”
ISLA has been advising the Saudi bourse on how best to facilitate securities lending and short selling. The kingdom will ease restrictions on institutions permitted to lend securities to enable foreign institutions to do likewise, says ISLA’s Dyson.
“While there are very good reasons for having rules stating you must have a particular account or be a certain type of institution to undertake a particular function, we’re trying to talk to the appropriate authorities to show them that there could be a more efficient way of getting things done,” says Dyson. “I wouldn’t underestimate these challenges, but they’re all resolvable.”
In Egypt, regulations to govern securities borrowing and lending have yet to be published, although the regulator has approved the concept of short selling and has issued brokers with short-selling licences ahead of its introduction.
“We’re still in the process of preparing the market participants,” says Amr Abol-Enein, managing director and head of asset management at Cairo’s CI Capital, which had 9.1 billion Egyptian pounds in assets under management (AUM) as of June 2019.
“We’re explaining the concept to our clients as we await the final phases of the regulations’ implementation mechanism – I would expect these to be released in Q4. Five or six brokers have been approved to do borrowing and lending and short selling.”
Enabling short selling will help increase the attractiveness of Middle East markets, especially to institutional investors, enabling them to both increase returns and hedge positions, providing an incremental revenue stream for long-term investors who lend their stocks.
“An underlying cause of market volatility is the fact that markets are essentially long-only – moves tend to get exaggerated because your only options are to be in or out of the market,” adds Masood. “A common objective of short selling is not just to have a naked short but to hedge your long exposure as well. Once you can short sell, you can participate on the way down as well.”
This article features in the Middle East and North Africa Securities Finance Guide 2019. Download the full guide here.
Interested in learning more about the MENA markets? Attend Global Investor’s MENA Asset Management and Trading Summit in Dubai on November 6, 2019.