Even as the fabric that once held together the brokerage industry in the United Arab Emirates comes apart, the steps taken by the country’s stock exchanges and its regulator to stich together the rips are hardly moving the needle. Of the 110 brokers that existed on the market at the start of 2011, almost half have now closed – of those remaining, only 10 percent turned a profit last year. 

To add to the misery of UAE brokers, their markets failed twice this year to be upgraded to ‘emerging markets’ status by the MSCI, an equity benchmark with $3 trillion worth of assets tracked by global investors. The effect the upgrade would have had on liquidity is widely debated, but the rejection has without doubt left local investors and brokers with a bitter taste in the mouths. 

Missing the MSCI mark

One of the key requirements for the upgrade by the MSCI was the introduction of ‘Delivery vs Payment’ (DvP), a mechanism in which the buyer’s payment and the receipt of the security is done at the same time. The old system required the investor to pay for a financial instrument at the bank that, only then, would go ahead and purchase it. The DvP settlement was introduced in the UAE in May last year but MSCI did not upgrade the UAE’s status from its current classification as a ‘frontier market’ at their June 2011 review, ostensibly because it did not have enough time to review the settlement process. 

Six months later, at the December review, MSCI declined to provide the UAE with the upgrade again due to investors having “significant concerns over the effectiveness of this new framework.” Investors and brokers now have to await the next review in June 2012, but they should not bet on the upgrade to save the thin liquidity in their markets. “MSCI is not a magic stick, it is one stick among many,” says Rached al-Balouchi, deputy chief executive officer at the Abu Dhabi Securities Exchange (ADX).  

“The key thing for change in the markets was beyond whether it would be included in MSCI. It has to do with the market itself. It is structural change that needs to take place in the markets,” says Malek Kanawati, CEO of Mubasher, one of the leading brokerage houses in the region. 

Numerous structural changes will likely be needed by these young exchanges, which have been operational for roughly only a decade. Several reforms such as short selling (betting on a stock to fall), security lending and borrowing (the process by which stocks are loaned to investors), as well as market making (allowing the broker to take on the risk of holding a security in order to facilitate its trading), have been suggested as ways to raise liquidity in the markets. A draft law, intended to bring life to these financial mechanisms, is currently in the making and widely anticipated by investors. The MSCI has stated that the introduction of these regulations could possibly resolve some of the issues that the UAE markets are currently facing.  

While practices such as shorting stocks have taken a lot of flack over the course of the global downturn, the UAE’s markets could stand to benefit from the much-needed injection of capital from institutional investors, even if that would open the door to a more speculative market. “When the whole world is going through a bearish period, you stop a whole group of investors from entering the market [when you do not allow short selling] and that group might be bigger than you think,” says Jeff Singer, CEO of the international stock exchange Nasdaq Dubai. He says that large financial institutions such as “Calpers, Fidelity, Vanguard could be bullish one day and bearish the other. With competing convictions, you enable people to keep the market liquid.” 

Another draft law was presented in December 2011 to also help raise liquidity in the parched equity markets. If implemented, this would be the biggest overhaul to the company law in the UAE in the last three decades. While no date has been set for the law, analysts in the UAE expect it to be enacted in early 2012. 

This law aims to implement unified accounting standards, change guidelines for share offerings and raise the foreign ownership limit, which currently stands at 49 percent outside of free zones. Following its implementation, foreigners could be majority stakeholders in a UAE company, a feature that should attract more international interest. The law also aims to make mandatory corporate governance principles for joint stock and limited liability companies. The pivotal feature, which would help the brokerage industry, is the allowance for private companies to list a minimum 30 percent stake as opposed to the current requirement of a minimum 55 percent stake, which entails a loss of control of the company when listing. This is a major stumbling block for private companies looking to tap the equity markets for financing. 

“The sooner the company law gets implemented, the better the chance of speeding up the recovery of the equity markets,” says Mohammad Ali Yasin, chief investment officer of Abu Dhabi based investment bank CAPM Investment. The new company law “will eventually lead to more listings and hence improved liquidity,” says Mohammad Al Dandashi, managing director at Abu Dhabi based Al Ramz Securities, one of the UAE’s leading brokerage houses.

Markets disconnected from economy

While these draft laws attempt to tackle some of the structural issues of the UAE markets, they fail to address several major hurdles, which are keeping the markets immensely illiquid. First and foremost, the UAE’s sound economy is not captured by its exchanges, as there is a limited diversification of sectors with banking, real estate and construction making up the vast majority of companies listed on the UAE’s exchanges. As these sectors are still struggling to grow, the UAE exchanges continue bleeding with the Dubai Financial Market (DFM) general index dropping 15 percent and the ADX general index dropping 11 percent in 2011.  

“Dubai’s economy is not fully represented in our markets,” says Essa Kazim, CEO of DFM. “For instance, the trading, logistics and tourism sector are not on the exchanges. Once we improve these things and sentiment improves, definitely liquidity will come back.” 

Exchanges in the UAE are not enjoying the same karma as the UAE’s economy, which is expected to profit from the regional unrest as investments and tourism fly their way from other countries in the Middle East and North Africa experiencing upheaval. The Emirates’ gross domestic product is expected to record 3.3 percent growth in 2011 and 3.8 percent in 2012, according to the International Monetary Fund (IMF), comparably solid output given the global and regional conditions. 

“It would help to see a wider variety of sectors represented on the exchange today if you want to capture the phenomenal growth seen in, for example, the UAE retail space, tourism, hotels or airlines,” says Tarek Lotfy, managing director at Dubai based Arqaam Capital, an investment bank specialized in emerging markets. 

Take for instance the UAE’s trade sector, one of the best performing sectors in 2011. It contributes 15 percent of the UAE’s GDP and it is not reflected on the exchanges. “We have witnessed a disconnect in the past six to 12 months in how the UAE is doing in terms of core businesses and how the markets are doing because there isn’t a way to effectively play the UAE growth story via the markets,” adds Lotfy. 

“Introducing new listings is still a key element for the liquidity issue. We need to diversify away from the traditional sectors like real estate and banking and see listings for industries and retail services,” says Reham Tawfik, head of brokerage at EFG Hermes UAE, ranked first on the DFM’s list of brokers on value traded in December 2011.

For a more diversified stock exchange, more companies need to be encouraged to tap the equity markets. While the draft company law might encourage some companies to list, more reforms will likely need to occur before the bourses reach their full potential. Listing a stake for some of the largest and most successful state-owned companies in the UAE, such as Emirates Airlines, Etihad Airways and Dubai Aluminum  would provide a strong sign of confidence to the investor community of the UAE’s commitment to its own equity markets.

 “We need some of the big successful government companies to go for initial public offerings (IPOs) despite the fact that they don’t need the cash. If they list part of their companies, this will give a very positive indication to the markets,” says Galal Khadr, head of private banking and wealth management at Abu Dhabi based Union National Bank, the only bank jointly owned by the governments of Abu Dhabi and Dubai. 

“There has been no official message saying markets in the UAE are undervalued, and there is great potential and we will put money in it,” says Yasin.  Kanawati disagrees: “This is the last thing governments want to do. You invest based on the merits of an investment and not for supporting an ailing market. If the market has structural issues, the best thing a regulator should do is let the free market forces take hold of the market and the quicker that happens, the better off that will be in the long run.”

Luring institutional investors

To create the conditions for more liquid stock exchanges, governments could also encourage certain institutional investors be more active in local markets. 

“We should have strategic funds involved in our markets such as pension funds. We need these types of funds involved to provide strategic value investment in our markets,” says Aymen Samawi, CEO of Abu Dhabi Financial Services (ADFS), the financial brokerage arm of the National Bank of Abu Dhabi (NBAD). Yasin believes that UAE federal funds should have a mandate to invest in local markets and not “treat this market as if it is any other market so if they don’t find depth they go and invest internationally.”

Institutional investors, which include federal funds, pension funds and sovereign wealth funds, are lacking on the UAE bourses. The vast majority of investors are retail investors who “rely on news from their peers and friends, unlike institutional investors who base their decisions on analysis, research and future expectations,” says ADX’s Balouchi. 

As institutional investors are more committed to the markets they invest in, raising their participation in the UAE could help equity flows.  Kanawati says he believes that companies should be more visible and go on more roadshows to explain their business model and discuss their expectations and future aspirations. Khadr agrees, noting that “marketing in MENA has to be much stronger than what it is today. You have to go and meet people, fund managers, etc. This is what will move the markets.” Dandashi also suggests increasing transparency and proper implementation of corporate governance from the listed companies’ side. 

If implemented, these suggestions could boost interest, but without addressing the structural issues, raising institutional participation on the UAE bourses will likely remain an arduous task.

Brokerage burdens

There are many other issues that brokerages are calling attention to but that have remained unaddressed, mainly the cost of running a brokerage in the UAE. To start with, the minimum paid up capital to set up a brokerage is 30 million dirhams ($8 million). Yasin suggests lowering this requirement: “Why doesn’t the regulator drop it to 5 million dirhams? It reflects market volumes.” 

 Brokerages in the UAE are also required to provide the regulator with a bank guarantee of 20 million dirhams ($5.5 million) in order to have access to the exchanges. Abdulla Hosaini, general manager of Emirates NBD Securities, the brokerage arm of Emirates NBD, the largest bank in the region by assets, suggests a floating guarantee linked to the revenues a broker makes. 

“So you are asking your broker who may not have that much capital to put up a huge amount of money that sits there unused,” says Nasdaq Dubai’s Singer. “A lot of brokers that are suspending their licenses still have a lot of cash, which is not being used for their business.” He suggests putting in place a clearing house model widely used in the West, which consists of a financial institution settling transactions on behalf of the exchange. “If I were to wave my magic wand, that would be the first thing I would do,” says Singer. 

Yasin says the clearing house model is a good idea in theory, but that moves financial liability from the broker to the regulator in cases of late settlement of a stock, which regulators are not willing to take. “I don’t blame them,” says Yasin.

Another cost incurred by the broker is the fees paid to the regulator on their trades. ESCA sets a maximum commission of 27.5 basis points on the volume traded, of which it takes 12.5 basis points, meaning 45 percent of the total commission goes to the regulator – an expensive price to pay. Brokers in Oman, for instance, pay 30 percent of the total commission to the regulator; in Qatar, they pay 20 percent.

“The fees need to be revisited,” says Khadr. “When the tough gets going, you have to take measures and when things get better, you can relax these measures.”

While lower fees will help brokers save money in these struggling times, they won’t help increase the drying volumes, with many brokers on their deathbed struggling for oxygen. While regulatory reforms seem to be en route, structural issues prevail, and without intensive measures to revive the ailing industry more brokers’ vital signs will soon be flat-lining. 

As Nasdaq Dubai’s Jeff Singer says: “We need to keep riding it out till the next cycle and then we can raise our abilities.” 

Stock exchanges in the Gulf Cooperation Council are still relatively young and have not reached the degree of sophistication of their Western peers. To discuss what GCC exchanges can do to evolve and what mistakes should be avoided, Executive sat down for a chat with Eric Bertrand, Principal Exchange Business Strategy Consultant for NYSE Euronext. 

What do you think are key barriers for an integration of the GCC exchanges? Are you pessimistic regarding the possibility of such integration?

I am not overly optimistic about the possibility of integration of GCC exchanges. The main barrier is probably political willingness. Technology is not a barrier and from a business point of view, there is no reason why it should not happen. The only reason why it is not happening is because there is a lack of focus on it; the need for it is not felt, which is strange as it seems to happen everywhere else in the world and it should happen in this region. 

The region has six different,  small countries and seven different bourses. This situation would be considered unsustainable anywhere else in the world. Investors around the world really consider the GCC and are interested in the region but I don’t think they are interested in any individual country; they are interested in the region as a whole. So if there were an institutional construction such as a regional cooperation that would bring to life one GCC exchange, it would certainly be extremely successful and probably more successful than the seven little exchanges working independently. 

What is certain is that when international investors look at the world, they look more at regions than at independent countries, especially when it comes to really small countries. A lot of international investors understand that people do business in different ways and they know that the GCC exchanges are not too risky in terms of systematic risk due to Sharia law banning derivatives trading and short selling. They are concerned about the lack of diversification of the GCC economies, the lack of liquidity among the exchanges and the limited number of listed companies. 

What should the top three priorities be for exchanges and regulators? 

The first priority should be an integration of exchanges and the development of a regional exchange. The second priority should be for the exchange to be more diversified in terms of sector representation and better reflect the economy. GCC exchanges are overpowered by the banking sector and then by the telecommunications sector. The tourism sector is not reflected on the exchanges whereas tourism is starting to strive in the region. Most airlines are state-owned although they are very successful and known worldwide; petrochemicals are generally not listed and state-owned; there are no big manufacturers listed on the exchanges. The third priority would be to align practices with international standards. Some of the mistakes the developed world made should not be replicated. Do not ‘copy and paste’ [the Western model] as that would be a nightmare. 

What mistakes should the GCC exchanges avoid?

Our CEO Dominique Cerruti, [has] mentioned… fragmentation of exchanges and the increasing opacity of markets — two consequences that result from a general belief in the benefit of overall competition. It is very unlikely for this to be replicated here, as the GCC does not have the size; the economies are small so they are naturally protected against these trends. 

The economies are… protected by the Arab culture and religion, which does not see speculation [in a good light] and generally forbids the use of derivatives. Financial innovation is much more limited, and “toxic” products such as CDOs [collateralized debt obligations] are unlikely to happen here. 

All emerging countries, including Arab countries, are looking to the Western world as a model because its development is older. The risk is that countries from the GCC see everything the West did as good, which it obviously [was] not. The evolution [of Western exchanges] was the product of our own evolution, culture and business practices and it is very hard to take something born under one framework and copy it onto another framework. There is one thing which I think is a basic reason why exchanges here are less developed than they are in the West, and that is because the business culture here is based on doing business with people you know, you lend money to someone you know, [and] if you need financing, you ask family or friends or your banker whom you’ve known for 20 years. 

The exchange itself is a venue for anonymity so it is very different from the way Arabs do business. They like doing business with people they know and the exchange is a way of doing business with people that you will never know. So if you go back to these basic elements, it is not that easy to copy and paste something designed with a Western mindset into the mindset here. 

In all Arab countries, most of the financing of projects is done by banks because it is done in a much more personal manner. In the West, we used to work this way, then in the 1970s and 1980s, we developed much more [complex] financial markets, where you can get financing from anonymous sources by using bonds, raise capital by issuing stocks and so on. It became a totally different way of thinking about doing business. 

What are your thoughts on the benefits of a merger between the Dubai Financial Market and the Abu Dhabi Securities Exchange?

A merger could only probably improve things in terms of volumes. It doesn’t make sense to have two exchanges in one small country. Look at Europe for instance. It is still made up of small countries such as France with a population of 60 million and Germany 80 million, which are much bigger than the GCC countries, and they still feel the need to merge their exchanges to bring out bigger liquidity pools and a bigger list of stocks in order to have a global exposure to international investors. The economies in these European countries are among the largest in the world and they still feel the need to merge. Here we have very small counties with very small exchanges and they multiply. This doesn’t fit the big picture.