While subdued oil prices have had a ripple effect on exchanges across the region, the Saudi Stock Exchange (Tadawul) has forged ahead with its bold strategy of reform. Having opened the door to direct foreign participation for the first time in 2015, in 2016 the exchange authorities and the market regulator are preparing for a new stage of development, which will see the Tadawul integrate further with global capital flows.
The inclusion of the exchange on leading emerging market indices is not without obstacles, but the reforms made necessary by the process should leave the Kingdom’s market a more transparent and investor-friendly platform.
The opening of Saudi Arabia’s exchange to foreign investors in 2015 is the latest chapter in the Tadawul’s growth story. The Arab Automobile Company, the Kingdom’s first joint-stock company, was set up in the 1930s, becoming one of a small number of public firms to emerge from the early days of the Kingdom’s development. The rapid growth of the modern nation meant that the power and cement industries were the initial focus of the nascent capital market, and by 1970s these sectors accounted for the majority of the 14 public corporations in the country.
The next decade saw a new phase of expansion in the Kingdom’s capital markets, driven by a nationalisation movement which saw many foreign banks and other financial institutions enter into joint ventures with Saudi companies. While the capital market was by then an established component of the economy, the lack of exchange infrastructure remained a barrier to growth. Trading took place on an informal basis through a network of private brokers, a system that by the mid-1980s was becoming increasingly inadequate for the needs of a corporate sector that was expanding rapidly on the back of the nation’s growing oil wealth. The government began to address the question of establishing a modern stock exchange, and in 1983 issued a royal decree that established a new ministerial committee made up of representatives from the Ministry of Finance and National Economy, the Ministry of Commerce and Industry, and the Saudi Arabian Monetary Agency (SAMA). This committee was given the mandate to develop and implement the regulations on which a formalised market could be built, while local commercial banks were authorised to act as its brokers.
In 1990 SAMA, in conjunction with the banks, established Saudi Arabia’s first electronic trading system, the Electronic Security Information System. The new platform linked 12 central trading units, operated by the banks, to a hub at the central bank, resulting in a more streamlined market, increased trading activity and a narrowing of price spreads.
In October 2001 the stock exchange implemented a more advanced system, capable of handling larger volumes that, after more expansions and enhancements, and then in September 2015, the current trading engine, Nasdaq INET Xstream, was launched. In 2003 the government introduced the new Capital Market Law, which resulted in the creation of a number of key institutions, including a new regulator for the market – the Capital Market Authority (CMA), the Securities Disputes Settlement Committee and the Appeals Committee.
The present structure of the Tadawul reflects the increasingly broad base of economic activity in the Kingdom.
Equities are divided into 15 sectors: banks and financial services; petrochemical industries; cement; retail; energy and utilities; agriculture and food industries; telecoms and IT; insurance; multi-investment; industrial investment; building and construction; real estate development; transport; media and publishing; and hotels and tourism.
From its starting point as a single asset class trading platform, the exchange has begun to offer a wider array of financial instruments. In 2010 it introduced the nation’s first exchange-traded fund (ETF), the investment instrument that first gained popularity in North American markets during the 1990s thanks to its ability to offer a basket of assets created from shares listed on the exchange, thereby providing an easy way for investors to create balanced portfolios and track indices using a basket full of stocks. The ground-breaking Falcom Saudi Equity ETF has since been joined in the market by the Falcom Petrochemical and HSBC Saudi 20 ETFs, and between them the three instruments had 249 subscribers in 2015, according to the CMA.
The ETF trading volume and value increased by more than 10 fold in 2015. While ETF subscriber numbers remain modest, their introduction to the Tadawul represents an important diversification of exchange products and chimes with the CMA’s long-term ambition of deepening the market. In addition, in 2016 the CMA approved securities lending and covered short-selling on the Tadawul. The establishment of a second market for small- and mid-cap companies is also being considered.
Despite the overall development of the Tadawul, the debt market side of the exchange has yet to see similar progress. The exchange launched an electronic trading platform for bonds and sukuk (Islamic bonds) in 2009, but currently the debt instruments listed on the Tadawul generate little market activity, with around one trade per month in the first quarter of 2016.
With a limited supply of instruments, investors prefer to hold to maturity, which leads to the lack of a vibrant secondary market in sukuk. “This is a very strong dividend market, because lots of investors buy stocks to hold and therefore put pressure on companies to provide good dividends,” Ziad Aba Al Khail, managing director of Aljazira Capital, told OBG. There is, however, a demonstrable appetite for debt investment vehicles. In 2015 some 68 private placement notifications for debt instruments were received. A relatively small number of sophisticated investors such as banks, insurance companies and funds bought these instruments. Conversely, only one public offering of debt was made over the year, the same number as in 2014 – it is easier to issue privately and there is sufficient demand.
Moving debt activity from the private to the public sphere and encouraging more issuers to list products on the exchange is a long-standing challenge, and the task of improving the framework surrounding debt instrument offerings and deepening the secondary market remains a strategic priority in 2016, according to the CMA. “Secondary markets have been promoted in the Kingdom over the last 15 years, but the market wasn’t ready,” Tarek Al Rikhaimi, CEO of Saudi Kuwaiti Finance House, told OBG. “The market has matured, and I expect the development of secondary markets to be successful in the next year or two.”
The strategy of the CMA, combined with that of the Tadawul authorities, has in some respects been the larger story over the past year, displacing the usual focus on index performance. The regulator has a broad range of responsibilities, spanning issuance of securities; listing; trading; settlement; credit rating agencies; investment funds; disclosure and governance; licensing and supervision; and enforcement of its regulations – all of which are delineated in the Capital Market Law and its implementing regulations.
At the technical level, the CMA has worked to introduce a supervisory regime that is both risk based and compliance focused, while at a strategic level it has cooperated with the Tadawul authorities to open up the market to foreign investment. The latter development has unfolded over several years, starting in earnest in 2008 when the CMA allowed limited access to foreign investors with the introduction of swap agreements. While this innovation enabled foreign investors to stock pick and receive dividends, their inability to claim voting rights and ownership of equities meant that this first stage of market liberalisation had only a comparatively modest impact on investor participation.
Foreign Investor Access
Following the opening of the market to select foreign investors, an even more significant liberalisation was signalled in August 2014, when the CMA published new draft rules for foreign participation.
The proposed rules were based on the qualified foreign investor (QFI) model, which had already been successfully implemented in other emerging markets. On June 15, 2015 QFIs and their approved clients were permitted to invest in the Tadawul for the first time, an historic development that has enabled foreign investors to become full beneficial owners of Saudi equities.
Throughout this process the CMA’s concerns have included market stability, to institutionalise the market, and to improve knowledge transfer and disclosures, and to this end it established a high bar to participation, including a stipulation that all QFIs must have at least $5bn in assets under management to qualify for participation and that they are only permitted to hold a maximum of 5% of issued shares in any listed company.
Moreover, to qualify as a QFI, an institution has to be a bank, brokerage, fund manager or insurance company. As a result, the list of nine qualified foreign investors approved by the CMA in 2015 reads like a roll call of the world’s most recognised asset management brands: HSBC Bank, Ashmore Investment Management, Silchester International Investors, Citigroup Global Markets, Ashmore Equities Investment Management US, BlackRock Fund Advisors, BlackRock Advisors UK, Ünlü Menkul Değerler and La Française Asset Management.
While the selective approach of the CMA has ensured smooth implementation of the new system, it has also limited the volume of foreign capital flowing into the exchange. According to Jadwa Investment, the nine months to March 2016 saw a net inflow from QFIs of SR794m ($211.7m), equivalent to 0.1% of market capitalisation. The CMA has therefore sought to raise the participation of foreign investors by announcing a number of changes to the QFI framework in 2016, the implementation dates for which will be announced in the first half of 2017. These changes include the broadening of the range of institutions entitled to apply for QFI status and the easing some of the requirements they must meet – for example, by reducing the assets under management minimum (see analysis).
In announcing the new measures, the CMA also revealed a number of regulatory changes that speak to a longer-term ambition: further integration with the global market through the eventual inclusion of Saudi Arabia in the MSCI Emerging Markets Index. The index tracks the performance of stock markets in 23 developing countries in total, and it is in turn is followed by active and passive investment funds, which benchmark their products against it.
Were Saudi Arabia to be included in the index, passive funds across the world would automatically adjust their portfolios to buy into the Tadawul, while the exchange’s visibility to active fund managers would be greatly enhanced. In its Market Classification Review of 2015, MSCI highlighted several issues it would seek feedback on from its participants, including the ownership cap on QFIs, which the CMA has addressed since this time.
Another potential barrier to inclusion on the index exists in the form of a T+0 settlement system, by which equity transaction dates and settlement dates are the same. The problem this poses to investors is that it requires them to pre-fund their securities account when an order is entered into the trading system so they can meet the instantaneous settlement requirement triggered when a trade order is carried out. This can then result in liquidity pressures, and in response many markets – such as those in Europe – have adopted T+2 settlement cycles, which allow investors to fund their securities accounts in response to only those equities orders that are executed.
The CMA has thus announced it will move to a T+2 system, bringing it in line with most other GCC markets, thereby encouraging more cross-border GCC transactions. Early 2016 also saw the CMA approve the introduction of securities lending and covered short-selling on the Tadawul.
These innovations will work together to allow investors to borrow and then sell securities with the intention of buying them back later at a lower price – a basic function of developed markets that allows investors to make gains in declining markets or hedge against other investments. By further harmonising the Tadawul with developed exchanges, the CMA is taking another step towards drawing institutional investor involvement.
Taken together, the reform measures of the CMA promise to substantially alter the investor base of the Tadawul. In 2014 Riyadh had the highest disposable income per capita among cities in the GCC, according to Zawya, a fact that helps explain the important role played by the retail investor on the Kingdom’s exchange.
In the fourth quarter of 2015 non-institutional investors owned 13% of the market, according to the CMA, but accounted for 79% of buy trades in the stock market and 86% of sell trades. So while the single largest ownership group is government-related entities, which accounted for 38% of the market at the end of 2015, the more volatile retail segment – made up of around 4.5m individual portfolios – determines the direction of the main index. This phenomenon is a mixed blessing: while the popularity of domestic stocks among the Kingdom’s investment community is welcome in terms of liquidity, it carries the side effects of speculation and volatility. This has resulted in exaggerations in both positive and negative movements since the 2008-09 global economic crisis, such as a 1500-point index jump in early 2012 on the back of encouraging economic news, followed by a sell-off that began in late 2014 as retail investors grew concerned that low oil prices would compel the government to trim expenditure.
The downward movement has been exacerbated by the need for many individual investors to liquidate securities in order to deleverage from margin calls as collateral values declined. The large number of retail participants on the exchange also results in seasonal volatility, with trading volumes declining in the summer months before regaining momentum in late autumn. The prospect of more institutional investors entering the market as a result of the new QFI regulations and their subsequent amendment is therefore a welcome one.
For now, however, the sentiment of the exchange’s volatile retail component continues to exercise a disproportional influence, and this has been reflected in the market’s performance over the past year. The principle measure of market performance is the Tadawul All Share Index (TASI), which establishes the general level of company prices based on the market value of free-float stocks of the listed companies. The same methodology is applied to the sector indices, which make up the next tier of market data.
After a volatile 2014, which saw the TASI reach a high of 11,149 points before declining oil prices soured market sentiment and brought the index down to a year-end level of 8333 points, 2015 saw a downward trend. At the end of the year the TASI closed at 6912 points, a decline of 17%. The first three quarters of 2016 saw a similarly negative trend, with the market posting a 18.6% year-to-date contraction to close at around 5623.
However, some of the sector indices showed gains over the year, led by the expansion of the media and publishing segment, the index for which rose by 57.3% in 2015. Other buoyant sectors included transport, which was up 7.5%, energy and utilities (1.4%) and real estate development (0.8%).
At the other end of the scale, the cement index posted a 33.7% decrease in 2015, as confidence in the industry faltered due to concerns regarding project slowdowns. Similar fears have also undercut the building and construction sector, bringing about a 30.4% fall. Other sectors that saw significant declines included petrochemical industries, which dropped 27%, and banks and financial services, down 14.9%. Market sentiment is likely to remain subdued as long as oil prices remain low. “In 2013 and 2014 the oil price didn’t move that much, so the TASI was driven by the internal dynamics of the economy. But once the oil prices drops to a certain level, the correlation becomes more important, when there is a funding problem,” Zaheeruddin Khalid, head of asset management and chief investment officer at Jadwa Investment, told OBG.
Despite the TASI’s direction over the past year, the Tadawul has maintained its reputation as a platform capable of delivering initial public offerings (IPOs) with remarkable regularity. After six listings in 2014, four firms went to market in 2015: the Saudi Ground Services Company, the Middle East Paper Company, the Saudi Company for Hardware (SACO) and Al Andalus Property Company. Offering values ranged from SR378m ($100.8m) to SR2.8bn ($746.5m), all of which were oversubscribed – in the case of SACO, by 12.1 times (institutions) and 6.2 times (individuals).
The Kingdom’s IPO market has always been attractive, thanks largely to the government’s view that a public offering is a useful means to distribute wealth throughout the population. For capital to flow into the accounts of retail investors in this manner, IPOs must be priced in such a way as to ensure a yield for purchasers. While some private firms engage in standard book-building exercises, historically, many IPOs of state-owned entities or companies with strong links to the state, such as those with fuel contracts with Saudi Aramco, come to market via a more managed mechanism at prices below true market value. The substantial discount that this practice engenders makes these IPOs attractive for all types of investors, including a growing number of IPO-focused funds.
IPO funds have seen growth as there is a push to get individual investors to participate in IPOs through funds rather than directly. This has been encouraged by giving more allocation to funds (see Alternative Investments chapter).
While the correlation between the TASI and oil prices means the close of 2016 and early 2017 will likely see a continuation of muted trading activity, the outlook for IPO issuance and debt market development is good. The CMA aims to grow the number of listed companies on the market from 170 at present to 250 over the next seven years, and publication of the National Transformation Programme in 2016 and the loosening of QFI regulations in 2017 will do much to further this plan.
On the debt side, the government’s need to balance its books in an era of low oil prices has already prompted the Ministry of Finance to signal a heightened sovereign debt programme, involving both conventional Treasury bonds and sukuk.
“Sukuk issuance is a possibility for the government as they have done so before. It remains to be seen if the sharia-compliant bonds would be released to the international market or only for Saudi Arabian investors,” Khaled Al Johar, vice-chairman of Aloula Geojit Capital, told OBG. In the meantime, the evolution of the Kingdom’s exchange will continue. The coming months will likely see more regulatory adjustment as the Tadawul readies itself for potential future inclusion in the MSCI, as well as other indices such as the S&P Emerging Markets Index. Other innovations currently under consideration, according to the exchange authorities, are stock options, real estate investment trusts – for which there is likely to be significant appetite from both issuers and investors – and the establishment of a second market on the Tadawul for small- and mid-cap companies, featuring less onerous listing requirements than those of the main board.
The Tadawul is also set to undergo significant alterations at the organisational level, beginning with a move to the self-regulation model that has already been adopted to some extent by a number of other exchanges in the region, including the Beirut Stock Exchange, the Amman Stock Exchange, the Qatar Stock Exchange and the Egyptian Exchange. The first phase of this process, which defined the future roles and responsibilities of the CMA and the Tadawul, has been completed, while the remainder of the transition will take place on a schedule determined by the need to maintain exchange stability, according to the Tadawul. The exchange is also in the process of converting its central securities depository to an independent company. The move to an independent custody model will likely be welcomed by QFIs, which are accustomed to such systems. Both of these organisational changes should pave the way to the eventual floatation of the exchange itself, which the Tadawul hopes to stage in 2018. Meanwhile, it is likely to continue widening its sources of revenue – 80% of which is currently derived from trading activity – to include more fees from services such as the provision of market data.
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