Formulating market regulation in the UAE is a symbiotic process, in which the Securities and Commodities Authority (SCA) works closely with the Abu Dhabi Securities Exchange (ADX) and its counterpart in Dubai. A long history of cooperation has enabled the regulatory framework to keep pace with the demands of the nation’s evolving capital markets – a tradition that has been maintained in 2012 with an array of draft rules being put out for consultation. The regulatory innovations expected to be approved in 2012 promise to bring a new degree of functionality to the ADX and are part of a broader aim to set the UAE’s markets on a path to greater depth and liquidity.
NEW DRAFT REGULATIONS: In November 2011 the SCA published a batch of draft regulations by which it intends to deliver three significant new functions to the UAE’s capital markets: market making, the practice of a broker or dealer holding shares in a security, offering a buy and sell price for them and seeking a profit in the spread; short selling, which will allow Abu Dhabi’s brokers to lend stock to customers who wish to go short on a stock that they believe will decline in price; and securities lending and borrowing (SLB), which enables the lending of stock to an investor or firm, usually for a fee.
Clearly, the three processes introduced by the proposed regulation are interdependent – an effective securities lending mechanism is necessary for the practise of short selling so that an investor can borrow stock from a broker, sell the shares and have the proceeds credited to his or her account, and then return the same amount of shares to the broker, having profited from the arbitrage opportunity should the stock have fallen in price since they were borrowed. The ability to borrow securities is also crucial to the market making component of the new legislation. At any given time market makers may find themselves selling more securities than they are buying, and the ability to lend and borrow shares is central to ensuring settlement efficiency in the market making process.
IMPLICATIONS: At a functional level, the new processes which the draft regulations promise to deliver will result in a more sophisticated market and bring the ADX into line with other developing exchanges. The availability of such new tools has the potential to revive trading activity and volume on the ADX, both of which declined after the global economic crisis. They will also provide a welcome respite to Abu Dhabi’s brokerages, which have suffered most as a result of the muted market sentiment that has persisted since 2009. Recent years have seen the exit of a number of firms, while those that remain have been compelled to lower their fees and commissions to retain clients. The new revenue streams that market making and short selling create will therefore be widely welcomed by the domestic brokerage segment.
Similarly, banks with custodian services in Abu Dhabi also stand to benefit from the ability to help their clients borrow and lend stock. While there is general agreement, then, regarding the potential of these changes to revive the market, the timeframe by which these benefits will become apparent is the subject of considerable debate in the local press. Some within the financial community point out that the relatively small number of stocks listed on the ADX will limit the volume of security lending, and therefore market making and short selling, for the short term.
THE BIGGER PICTURE: While this may be true, it is also worth remembering that the regulatory package proposed by the SCA is part of a larger strategy that aims to boost liquidity and listings in both of the UAE’s government-run exchanges. For some years now, the UAE has been working with global indexers and investment support firms to raise the nation’s ranking and tap into the trillions of dollars’ worth of capital that is invested according to their various data sets. To date, it has had considerable success in this regard. In 2010, the FTSE Group was the first such institution to grant the UAE “secondary emerging market” status, thereby opening the door to some of the $3trn of funds that track the London-based index compilers’ benchmarks. The action resulted in a useful boost in market sentiment during a difficult year, and raised hopes that other reclassifications would soon follow.
The following year brought more welcome news. In August 2011 global fund manager Russell Investments upgraded the country from “frontier market” status to the “emerging market” category. The UAE is the only GCC economy to have been granted such an upgrade by the US firm, which based its decision on an assessment of the nation’s performance in terms of market accessibility, operational risk, market size and inevitability measures, as well as taking into account macro factors such as GDP per capita, market capitalisation to GDP and the UAE’s favourable placing according to the World Bank Income Category.
A BID FOR NEW STATUS: For many in the financial community, the ultimate prize has yet to be won: a reclassification to “emerging market” status by the US-based MSCI. The global indexer’s benchmarks are tracked by investors with around $7trn in assets, and securing the classification upgrade is widely viewed as central to SCA’s efforts to boost liquidity in the UAE’s markets. Meeting the stringent requirements laid out by MSCI has kept the market regulator busy for some time, and its efforts to meet this objective have significantly influenced the formation of its regulatory structure in recent years. The proposed market making, short selling and SLB regulations are among the processes which the MSCI takes account when assessing the exchanges within its coverage, but they represent just the most recent phase of reform.
In May 2011 the UAE implemented a delivery-versus-payment (DVP) service, whereby the delivery of securities can now take place simultaneously with payment for them. The lack of such a system had been cited by MSCI as a reason for not upgrading the market, and its introduction therefore raised hopes that a reclassification would take place in December 2011. However, MSCI was not minded to move quickly, and at the close of the year announced that it needed to “give additional time for market participants to assess the effectiveness” of the DVP system, deferring its decision until June 2012.
The announcement in June 2012 that the UAE and Qatar, the other GCC nation in line for a status upgrade, would remain under reclassification review for a further year therefore came as a disappointment to the market. However, most agree that the UAE’s upgrade to “emerging market” status remains a likelihood rather than a possibility. By the next evaluation, the DVP system will have had time to demonstrate its stability, and the new market making, short selling and SLB functionalities should have been firmly established.
FOREIGN OWNERSHIP: The remaining conflict between the MSCI’s stipulations and the domestic regulatory environment, it is hoped, will also have been resolved as the 49% upper limit on foreign ownership of listed companies now represents the most significant outstanding issue in relation to the MSCI’s requirements. In this regard, the UAE has less distance to travel than Qatar, which maintains a 25% maximum limit, and it is hoped that a compromise between the MSCI’s strictures and the UAE’s wish to protect its national assets can be reached soon.
The question of foreign ownership also remains one of principal rather than a practical challenge. “Foreign ownership has not been an issue for investors in the UAE’s financial markets, in fact, all companies whose shares can be purchased by foreigners have current foreign ownership comfortably below the limit,” Ryan Lemand, the senior economic advisor and head of risk management at the SCA, told OBG. The recent publication of a draft UAE Companies Law also suggests that authorities may be willing to change the rules. Among the draft law’s key features is provision that would allow the Cabinet the authority to issue further legislation granting companies that carry out “certain activities” to maintain a foreign shareholding component exceeding the current limit of 49%. This would represent a significant policy change, and one that would doubtless be welcomed by MSCI.
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