An expanding market: New regulations and the introduction of a second bourse have boosted the Kingdom’s appeal

With new regulations, the continued implementation of development strategies and the historic opening of the nation’s second exchange holding the interest of market participants, Bahrain’s capital markets have been receiving significant attention from investors. However, a number of challenges have presented themselves as well. The European debt crisis, local and regional unrest, and the lingering effects of the global economic slowdown have combined to create a difficult environment for exchanges across the Gulf. Nevertheless, expansion continues, with new products planned for both of Bahrain’s exchanges in the coming year, and regulatory reform aimed at creating a more attractive investment environment is under way.

HISTORY: Bahraini firms have been raising funds in a domestic capital market since 1957, when stakes in the nation’s first public shareholding companies changed hands in the informal Al Jowhara Market. The early 1980s saw this, and similar, non-official markets in the region suffer a crash – an event that convinced the Bahraini authorities of the need for a formal capital market. After completing a feasibility study in conjunction with the International Finance Corporation, the government issued Amiri Decree No. 4 of 1987, thereby creating the nation’s first official bourse: the Bahrain Stock Exchange (BSE).

The BSE officially began operations in 1989, with 29 listed companies and a manual trading system. A decade later, the BSE upgraded from this auctional method to an automated trading platform. This development marked the beginning of a period of expansion that saw the BSE evolve from a single-product exchange to become one of the first markets in the region to offer preferred shares, bonds, sukuk ( sharia-compliant debt instruments), and mutual funds.

In 2010, the BSE had another transformation: in addition to moving to its new location in Bahrain Financial Harbour, it rebranded as the Bahrain Bourse (BHB). It also changed its legal status, going from being a state-owned entity to a closed shareholding company.

THE BHB TODAY: As of April 2012, the BHB is home to 49 listed companies that are present across a number of defined sectors: commercial banking, investment, services, insurance, industrial, hotels and tourism, preferred share, closed company and non-Bahraini company. Manama’s status as a regional financial centre is reflected in the composition of its exchange, which is weighted towards financial services.

Eight commercial banks, including National Bank of Bahrain and Bahrain Islamic Bank, represent the largest single sector on the bourse, accounting for 38.8% of market capitalisation in third-quarter 2011. Twelve investment companies form the second-largest group (28.84%), and include in their number the local conventional and sharia-compliant firms such as Al Baraka Banking Group and Gulf Finance House which have played prominent roles in the economic development of the region. The five listings in the insurance category, meanwhile, contain some local players, such as Al Ahlia and the Arab Insurance Group, which have contributed to Bahrain’s reputation as the Gulf’s insurance centre. Of the non-financial sectors, the nine listings in the services category made up 30.89% of market capitalisation in third-quarter 2011, including such giants as the Bahrain Telecommunications Company (Batelco), followed by hotels and tourism with five listings and 3.36% of the market. The industrial sector accounts for 12.4% of market capitalisation despite holding just three listings, thanks largely to the presence of Aluminium Bahrain (Alba) – one of the largest aluminium smelters in the world and a significant contributor to the national economy.

FOREIGN LISTINGS: As well as the five leisure companies that make up the BHB’s hotels and tourism sector, accounting for 3.3% of market capitalisation, five foreign firms have listed on the exchange. These include Bank Muscat, Global Investment House and the Sudan Telecommunications Company.

ADDITIONAL PRODUCTS: Bahrain’s bourse has developed beyond its core activity of equity listing. Since the introduction of formal regulations governing mutual funds in 1992, growth in this segment has been exponential and Bahrain is a long -established centre of fund activity. There were 2831 funds marketed in Bahrain in the third quarter of 2011, according to the Central Bank of Bahrain, with total assets of $8.32bn. Of these, around 127 were locally incorporated, for a value of $4.98bn. As of first-quarter 2012, the BHB plays host to 31 of them, all open-ended.

The BHB also incorporates a debt market that contains 11 bonds and sukuks. The government plays a leading role in debt issuance, with regular sales of short- and medium-term T-bills. While a planned $1bn bond sale was delayed in February 2011, in September state news agency BNA reported the government had set up a framework to issue up to BD3.5bn ($924m) in bonds, earmarking the proceeds of the sale to help bridge its projected budget deficit.

As of April 2011 the market was served by 12 brokers. The largest of these is Securities and Investment Company (SICO), one of eight that operate on investment bank licences. In most cases these firms have an advantage over the remaining “List A” and “List B” firms, operating on individual broker licences, as they can access the clients of their bank’s retail division.

TRACKING THE BOURSE: Brokers, clients and other BHB participants can maintain market oversight through a number of indices. The Bahrain All Share Index, which includes all actively traded companies, dates back to 2004 and remains the market benchmark. It has been further broken down into a series of minor indices based on each market sector.

The following year it was joined by the first privately administered tracker on the bourse – the Esterad Index. Owned by a local investment firm which is itself a listed company on the BHB, the index follows the price movements of 22 listed companies, selected in accordance with criteria including sector representation balance, market capitalisation and liquidity.

In 2005, what was then the BSE joined forces with Dow Jones to create the Dow Jones Bahrain Index, which has the stated objective of representing all companies domiciled and headquartered in Bahrain whose stocks trade on the bourse. This variable component number, full market capitalisation index is reviewed quarterly, and uses the proprietary Dow Jones sector classification system. This is significantly different from the BHB’s sector structure, and therefore allows participants to view the bourse in an alternative fashion. According to the Dow Jones Bahrain Index data for March 29th, 2011 the financials made up 66.96% of the BHB’s value, followed by basic materials (16.53%), telecommunications (12.65%), consumer services (2.80%), industrials (0.67%) and finally consumer goods (0.42%).

PERFORMANCE: While the values of Bahrain’s three major indices vary slightly, all have recorded a similar pattern of expansion and contraction since 2006. Like most of the world’s markets, the BHB saw a reduction in both trading activity and market capitalisation in the wake of the global economic downturn. However, its status as a relatively low-volume market, which had been a challenge prior to 2008, served as a mitigating factor in the years which followed, and the BHB’s decline was not as precipitous as were the declines for others in the region. “As an open economy we are not isolated from regional and local events, and we were impacted by the deteriorating global economic environment. But we lost relatively little in terms of value and volume, compared to the global market,” said Ebrahim Jaffar Al Aradi, the head of trading and members affairs at the BHB.

Nevertheless, Bahrain’s recent history of growth and contraction is a familiar one in the region: an uninterrupted rise in market capitalisation from 2002 peaked in 2007 at $10.19bn, before falling off to $6.1bn in 2009. A modest rally in 2010 saw market cap increase to $7.57bn, but the political protests seen in 2011 and an Alba decline resulted in a decrease in value to $6.25bn by the end of the year. The Bahrain All Share Index fell by 20.15%, according to figures from the BHB and Global Investment House. While declines were recorded across the bourse, the investment index posted the largest decrease, at 28.8%, by followed by the industrial index (a decrease of 26.7%).

GROWING THE MARKET: While local political developments, regional unrest and the incremental nature of the global recovery are beyond the influence of the BHB, the exchange’s management continues to take steps aimed at growing the market. “Working with the CBB and the Ministry of Industry and Commerce (MoIC), we are developing a strategy to develop the market. Within the BHB we have our own strategy. While it is composed of many elements, the priorities for us are increasing the number of listed companies, introducing new products and making the bourse a more attractive environment when it comes to investors,” Al Aradi told OBG.

The amendment to the listing rules in 2011, which makes it easier for companies to come to the bourse to raise capital, was a manifestation of the BHB’s facilitative approach. This was in line with the combined efforts of the MoIC and the CBB efforts to upgrade the corporate governance regime in regard to the financial sector (see analysis).

ADDITIONAL IMPROVEMENTS: More innovations are expected in the short term. Foreign investors can now own 100% of shares or bonds. Further, in late 2011 the BHB announced its intention to introduce short-selling in a bid to boost trading volume. Providing market participants with a means to profitably trade on a declining security will effectively give the BHB – presently a “one-way” market – a product range that runs across the entire credit cycle. The BHB also plans to introduce a delivery-versus-payment (DvP) system, whereby delivery of securities is carried out simultaneously with the payment.

The introduction of DvP removes the risk of default by either seller or buyer with obvious benefits to market confidence and efficiency. While both initiatives are part of the BHB’s strategy to increase market activity, they also form an essential element of the bourse’s bid to meet the listing requirements that will allow it to upgrade from a “frontier” to an “emerging” market according to the Morgan Stanley Capital International (MSCI) Index. Such a promotion would place Bahrain within a cadre of rapidly developing economies that includes Brazil, Chile, China, Czech Republic, Hungary, India, Indonesia, Korea, Philippines, Russia, South Africa, Taiwan and Turkey. It would also strengthen Bahrain’s position as a financial centre in the GCC, where both Qatar and the UAE have applied for a similar upgrade.

BFX: While the short-selling soon to be introduced on the BHB represents a considerable structural enhancement to the market, investors looking for other advanced instruments to hedge their portfolios and trade muli-asset products can now look to a brand new institution in Bahrain. The Bahrain Financial Exchange (BFX) opened for business in 2011 as the first-ever multi-asset exchange in the Middle East, and is internationally accessible to trade cash instruments, derivatives, structured products and sharia-compliant financial instruments for raising capital, managing risk and investing.

Wholly owned by India’s Financial Technologies Group, which runs a network of 9 exchanges across the Middle East, India and South East Asia, the BFX has started out with a carefully selected number of products which it plans to expand on during 2012 and beyond. BFX gold futures, available for trading at a contract size of 32 troy ounces, are aligned with prices in the international reference markets so as to provide a uniform price risk management strategy. A futures contract based on the euro and US dollar (BFX EURUSD) has a lot size of €25,000, while a natural gas futures contract is a response to the increasing need by producers and consumers of crude oil, natural gas and distillate products to mitigate price risk.

The BFX has also launched a unique index futures contract on the dollar versus the Indian rupee, which was named the “most innovative forex product” of the year during the 2012 Jordan Forex Expo. Yet another achievement will be the launch of the BFX Dow Jones SAFE India Index Futures. Its launch will facilitate investors to diversify their investment portfolios with exposure to the Indian economy, which is one of the fastest-growing in the world. The small contract size for the BFX Futures allows retail investors as well as small- and medium-sized enterprises to trade on the BFX markets at narrow bid-ask spreads.

One of the more innovative aspects of the BFX is Bait Al Bursa, a division of the market which represents the first dedicated platform in the region to offer exchange traded solutions to the Islamic finance market. Its first product offering, e-Tayseer, is a fully automated platform supporting transactions in the supply, purchase and sale of assets for facilitating Murabaha transactions – a GCC first.

“If you want to broaden the sharia-compliant financial market and bring in more structured products and more volume-based business, one way is to integrate the latest trading technologies into the traditional methods of conducting murabaha transactions,” Arshad Khan, managing director and CEO of the BFX told OBG. “In that direction, Bait Al Bursa developed e-Tayseer as a fully automated liquidity management solution for murabaha transactions. Prior to e-Tayseer, murahaba transactions were conducted in a manual manner, making the process less efficient due in part to handling time, human resources requirements and processing costs. The new structure lets banks and institutions supply, purchase and sell assets electronically, in a sharia-compliant manner and through a secure, robust and transparent platform.” The product is the first of what the BFX claims will be the most diverse range of sharia-compliant instruments in the region. Bahrain’s new exchange operates on a member-to-member system by which trading is conducted through authorised users, which can then offer products and services to clients. Attracting companies, which can avail of various membership types with varying trading and clearing rights, is therefore a priority for the BFX as it starts to expand on its initial product offerings (see analysis).

REGULATION: In their efforts to grow their businesses, both the BHB and the BFX benefit from one of the most widely respected regulatory regimes in the region. The CBB was established as the regulator for the entire financial sector in 2006, taking oversight responsibility for the bourse from the Bahrain Monetary Agency. Since that time it has worked with the BHB, the MoIC and, more recently, the BFX to ensure that the regulatory framework within which the nation’s capital markets operate remains in line with international best practice. Its oversight of the wider financial sector means that all market participants, including conventional and Islamic banks, insurance companies, investment firms and brokers come within its purview, and it regulates the interactions of these bodies through the policies laid out in the CBB Rulebook. The activities of Bahrain’s capital markets are addressed in Volume 6 of the Rulebook, the development of which began in 2008. Mindful of the plans to establish a second exchange in Manama, the CBB’s Capital Market’s Supervision Directorate (CMSD) first created the markets and exchange module, which establishes the framework for licensing exchanges and laid out a clear route for the BFX’s foundation.

REGULATORY ADVANCEMENTS: By early 2012 the CMSD had finished all of the major licensing and authorisation modules, released the first codified takeovers, mergers and acquisition module in the region and incorporated within the rulebook the corporate governance code which the MoIC had made effective at the beginning of 2011. Its focus for the remainder of 2012 will be on its new offering of securities module, which will be put out for consultation during the year. The new module promises to significantly enhance the process of offering securities, and will replace an array of regulations which are presently fragmented among a number of documents and circulars. The BHB’s amendments to its listing rules, the corporate governance code issued by the CBB and incorporated into the CBB Rulebook, and the CBB’s new Offering of Securities module combine to greatly enhance the relationship that currently exists between the bourse and its listed, or potentially listed, companies (see analysis).

OUTLOOK: The local and regional unrest which negatively affected the performance of the BHB during 2011 did not divert the exchange from its strategy of structural reform, and its bid to upgrade from an emerging to a frontier market remains a realistic one. While attracting liquidity will likely remain a challenge in the short term and, as with other bourses in the region, growth is to a large extent dependent on a number of extraneous factors, a domestic driver exists in the form of Bahrain Mumtalakat Holding Company and its sizeable portfolio.

The investment arm of Bahrain successfully sold off 11.5% of Alba in late 2010 through an initial public offering, an event which some have interpreted as the beginning of a process of privatisation which will see Mumtalakat divest itself of more assets and result in more listed companies on the BHB. The BFX, meanwhile, will concentrate its efforts on rolling out new products and attracting more members in the short term. The performance of the new exchange in its first months of operation has been encouraging. “Having started in November 2011, month-on-month our volumes have been growing steadily. We started at around 36 contracts a day, and around $1.5m to $2m in value. In the beginning of May 2012, the single-side daily trading volume peaked at 3220 contracts, with a daily trading turnover of $163m on May 8, 2012,” Khan told OBG. On May 8, 2012, the cumulative trading turnover of the BFX Futures (since its launch date in November 2011) was more than $1.77bn.

Challenges undoubtedly remain ahead for both of the Kingdom’s exchanges. However, new products, as well as improved regulation and domestic expansion opportunities, underpin future growth prospects.