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Headlines continue to emphasise a fact well-known to exchange pundits: one cannot create liquidity out of a vacuum and liquidity is the name of the game. The L word is what matters; it is the reason why companies seek out certain exchanges for listings, and it is why investors and intermediaries flock to those exchanges. A virtuous cycle of sorts is at play. Higher liquidity leads to higher valuations of listed securities. This, in turn, attracts more listings, which lead to more investors and intermediaries, fuelling higher liquidity levels.
There is no doubt that we are witnessing the creation of galaxies of international liquidity surrounded by a sprinkling of stars which we might classify as Niches and Nodes, with some more sparkling than others. The question for Middle Eastern exchanges these days, as well as many others in emerging markets, is: which of the two N-s do they want, or need, to be?
Amalgamating liquidity across borders and boundaries, both product and geographic, is becoming part of the new business paradigm for the exchange industry. So far, and through differing evolutionary processes, two distinct international liquidity streams have emerged: NYSE Euronext and Nasdaq OMX. A third is waiting to be born, most probably on the shoulders of Deutsche Börse.
Some exchanges in the Middle East have already heard the war cries and joined the fray. Borse Dubai currently controls a substantial minority stake in Nasdaq OMX, giving the latter an opportunity to access GCC capital markets and other Middle Eastern and emerging economies. The Qatari stock market is finalising the sale of a stake to NYSE Euronext which will provide the first transatlantic exchange with entry into a geography that rivals that of Nasdaq OMX. Additionally, one may safely assume that NYSE Euronext will be able to count on Qatar’s financial muscle for future strategic moves that it may chose to purse globally. Not to be outdone, Deutsche Börse has established a technical relationship with Kuwait that could very well lead to some form of a strategic alliance, provided the German exchange has enough acumen to navigate Kuwaiti politics. Future moves by the exchanges of Abu Dhabi, Egypt and Saudi Arabia should not be discounted. Tunisia and Morocco are also pondering their strategies.
All this is good news for GCC and Middle Eastern companies, investors and intermediaries. Or is it?
The question for these and other stock markets in the Middle East is whether ties to the big boys will connect the region’s liquidity pools to international ones; or whether they will simply amount to subsidies to enable global exchanges to pursue grander visions with the use of Arab money – an outcome that has been apparent in other industries and sectors, with little added value to the economies of the Middle East. Time will tell. But so will a careful examination of the agreements signed or proposed.
Niche or Node will be the only choice for many exchanges in emerging markets, including those operating in the Middle East. As worldwide liquidity gravitates towards fewer global streams, an exchange operating in a developing country will have to choose. It can function as a liquidity node, connecting its region’s economy to world capital markets, benefiting listed companies, investors and intermediaries. Or it can specialise in terms of geography or product offering. Dubai and Doha seem to have chosen node; sooner or later, other Middle Eastern exchanges will have to make a similar choice. Their decision-making processes will be influenced by several factors, one of which is recent market behaviour.
The region’s exchanges were off the radar screens of most international investors for many years. GCC stock markets in particular experienced their own version of irrational exuberance, peaking in November 2005 and driven largely by local investor appetite and speculation. The markets eased throughout 2006, hitting bottom towards the beginning of 2007. With earnings growth percentages in the 20s and 30s and P/E ratios in single digits, it did not take long for international investment funds to realise that they had discovered a new alpha and a wave of foreign buying swept the region, pushing the MSCI Arabia index up 47% in 2007.
It is difficult to say with certainty which portions of those funds sought long-term gains and which were hot money. Among the Special Sits, Quants, Macros and a plethora of new names for an old theme that cropped up in London’s Mayfair and midtown Manhattan, international funds were betting on anything and everything in the GCC and Middle East/North Africa, from currency revaluations to real estate booms to international mergers and acquisitions. Finally, the credit crunch had its say, the bubbles burst and the long unwind began.
Hence, 2007 was a seminal year for Arab stock markets. The entry of international funds hammered home the importance of foreign capital in supporting stock valuations. Their exit taught how fickle most of these funds are, and the value of cultivating and maintaining relationships with one’s shareholders, both local and foreign. Should Arab stock markets function as nodes, facilitating the entry and exit of foreign capital with the resultant upheavals? Or are these links essential to the development of the region’s economies?
2007 was also important for the Middle East because in that year an Arab exchange holding company, Borse Dubai, launched a takeover of a European stock market, OMX, paving the way for new thinking regarding the future development of the region’s exchanges.
Throughout history, competition and brinkmanship have walked hand-in-hand. They do so in today’s Middle East. One does not have to look far to see their footprints on the political landscape. With the surge in oil prices since 2003, economics and capital markets have provided them with an additional stage. The Qatar-Dubai debacle over OMX was a poignant example of how things can go wrong in this part of the world. Hopefully, lesson have been learned and more poised strategies can be followed by the region’s exchanges.
Arab stock markets aspiring for regional leadership will have to position themselves favourably vis-à-vis the formation of international liquidity streams that is taking place globally; a shifting of tectonic plates in a traditionally stratified sector. And three challenges need to be addressed.
First, for an exchange to become a regional financial hub, it needs to function as a node for liquidity; connecting not only its own liquidity pool but also those of the region to one or more of the emerging global liquidity streams.
Second, to become a liquidity integrator, an exchange has to have some form of ownership right to a technology development process; leasing trading and clearing platforms is good for running a local exchange, but not good enough to play the liquidity integration game at regional and international levels.
And third, an exchange needs to start in its own backyard, acting as a catalyst for the integration of liquidity pools in its immediate vicinity and then connecting the emergent, larger liquidity pool to the mega exchanges globally.
These challenges are further complicated by the fact that most exchanges in the Middle East are government owned. Hence, integrating liquidity pools via mergers, acquisitions, share swaps, and minority or majority shareholdings is difficult to implement, though by no means impossible. Qatar’s deal with NYSE Euronext clearly shows that where there is a will, there is a way.
The niche strategy is no less daunting than the node approach. Some exchanges in the Middle East may choose to specialise in serving certain geographies. The Palestinian stock market is a good example of this with a ‘lock-in’ situation that is a function of a particular political reality.
Other exchanges may enjoy a certain comparative advantage that would enable them to specialise along certain product offerings. Bahrain, with the region’s longest track record in Islamic finance, may very well choose to specialise in the listing and trading of Islamic finance products. Abu Dhabi, with one of the world’s largest petroleum reserves and a major investor in energy projects worldwide, may choose to emphasise the listing and trading of energy company securities. Abu Dhabi has also been actively seeking to lead the listing and trading of exchange traded funds in the region. It may end up being one of a handful of exchanges that are able to successfully provide this type of product to investors.
Other Middle East realities are also expected to influence the future development of exchanges in the region. Times ahead will be tough regardless of the size of hydrocarbon deposits. Populations in Arab countries are growing faster than jobs are being created. Large swathes of non-GCC Arabs are living at or below poverty lines. The current global economic recession is adding momentum to calls to renegotiate the social contract between the ruling elites and the ruled in the Middle East, and pressure will continue to mount for a more equitable sharing of both political prerogatives and economic benefits.
One result of this will be the unbundling and privatisation of state monopolies and cash cows, and the region’s stock markets will be prime candidates to undergo this process. Privatisations of exchanges in the Middle East will be propelled forward by demands for a fairer distribution of the economic pie. However, other factors are also at play. Many of the region’s investors, middle class families and labourers, lost considerable sums during the recent downturn in the region’s stock markets. Privatising exchanges and allowing investors to own shares in them would go some ways in alleviating investor grievances that are currently morphing into various forms of political discontent.
Corporatising, privatising and listing Arab exchanges will have several positive consequences. Governments will receive cash that can be utilised to alleviate pressing social and infrastructure needs in a world where cash has become dear. Once they own shares in the local exchanges, local investors will trade more. Various types of alliance between the region’s exchanges can be realised more easily once they can own shares in each other. A more competitive exchange landscape will begin to emerge, and alternative trading platforms will have a window of opportunity.
It is not impossible to see, in the not too distant future, a group of Middle East investors teaming with a Chi-X or a BATS to launch a regional network for the trading of certain securities. Riding on the coat tails of price discovery on the region’s exchanges, such an alternative route would offer cheaper and more efficient trading services. Trading fees in the region are high by international standards and some exchanges are operating with EBITDA margins of around 90%. There is considerable room for competition, provided that regulatory bodies go along with this. Alternative initiatives can rally political support and gain regulatory approval to superimpose technological solutions and business models on discrete liquidity pools in the region, thereby leading to integrated or semi-integrated regional solutions.
Contrary to previous efforts in the region, the entry of alternative trading networks will not be a test of the adage of ‘if you build it they will come’ in an exchange setting. Rather, it will be an act of carving liquidity out of a certain market and re-depositing it somewhere else, and with good reasons for doing so; something that some of the recent initiatives in Europe seem to have missed.
Privatisation of Arab stock markets will also open a ‘back door’ for the integration of the region’s liquidity pools. Privatisation will create the possibility for exchanges to carve out clearing and depository functions into separate legal entities, paving the way for the formation of regional CDSs. This will allow the region’s stock markets, which up till now have followed a silo business model, to capitalise on previously untapped revenue streams embedded in their depositories. Be it corporate actions related to general assembly meetings, shareholder identification or other generic services provided by depositories worldwide, Middle East offerings in this field are not yet there. The emergence of a few professional regional CDSs will also enable the exchanges to offer a more secure cross-border clearing and depository service, raising comfort levels of local and international investors and leading to higher liquidity.
Middle Eastern companies are moving from being successful local operations to becoming regionally competitive enterprises with, sometimes substantial tranches of international activities as part of their portfolios. In doing so, they have gained added appreciation of the role that equity plays in their capital structures. Companies are realising that for the Middle East to evolve into an internationally competitive region with successful industry clusters, they need to expand their equity base. Raising seed and venture capital, seeking private equity injections for turnaround or growth, and going public and seeking listings on liquid exchanges are becoming common practices in a region that has traditionally relied on debt.
As Arab exchanges come of age, they will look for new and better ways to service stakeholders. Sector consolidation is already leading to the creation of regional heroes. The compression of dispersed regional economic interests into single corporate entities with regional and international mandates is putting pressure on exchanges to respond. Instead of a race to the bottom, Arab stock markets will soon start on a different kind of competition to gather regional liquidity. Their international alliances will provide another way in which the region is becoming inexorably linked to the rest of the world; something that is of immense benefit to companies, investors and intermediaries, and an exciting development that will usher in new opportunities and challenges.
Majd Shafiq is Managing Partner of United Advisors, was formerly Senior Advisor to the Dubai Financial Market and Borse Dubai. He can be contacted at mns@unitedadvisors.org.
