Legislating change: Empowering the regulator and cleaning up the market

A legacy of privatisation, Mongolia’s securities law continues to hamper the development of the world’s second-smallest bourse. While new legislation has been drafted with support from an international working group that included the London Stock Exchange Group (LSEG) and presented to parliament, its passage remained delayed in 2012. Although smaller pieces of legislation have passed in recent years, and new trading and settlement mechanisms have been installed at the Mongolia Stock Exchange (MSE) since July 2012, market actors remain on standby as they await the new law. Legislative progress is key to establishing a domestic platform that can fund large-scale investments like financing strategic deposits and the mining sector overall, in addition to other sectors.

NEW RULES: Key to partnering with the LSEG is the overhaul of Mongolia’s securities legislation of 1994 and 2002 (revised in 2005). Although 2006 reforms created the Financial Regulatory Committee (FRC) as the market regulator, rules were geared to the needs of individual Mongolian investors rather than institutional and foreign managers. With the majority of securities listed on the MSE untraded and with minimal floats, a new supply of listings lags far behind economic growth.

A draft of the new laws was ready for parliamentary hearings at the start of 2012, covering all major aspects of the securities business. The bill simplified listing requirements and modernised the IPO process, incorporating part of the UK’s Financial Services Authority listing rules that clarify market and prospectus terms.

In addition, the new law simplifies and systematises the various procedures for delisting, forcing inactive firms to value shares and pay shareholders “appropriate” compensation. Moves to strengthen the FRC’s ability to prosecute infringements and ensure transparency are designed to clean up the market and enforce more open financial reporting. The criteria for MSE membership are also clarified, establishing an independent board, for instance, as a necessary first step in corporatising the exchange.

However, repeated delays in 2012 have frustrated traders eager for reform. Following circulation through the exchange, the FRC, the Bank of Mongolia (BoM), other ministries and political committees, and support from the LSEG and donors, the bill was expected to pass following parliamentary hearings in the first half of 2012, prior to legislative elections in June. However, high-profile debates on the Strategic Foreign Direct Investment law passed in May pushed the draft law off the spring session’s programme. However, the new cabinet has emphasised its support for rapid passage of the bill in its four-year plan in September 2012.

CLEAN-UP JOB: With an average free float of a mere 8%, market capitalisations as low as $500 and only about 40 of the 330 listed stocks traded daily, a cleanup is needed. “The vast majority of companies listed on the MSE may not actually want to be listed, they merely happen to have a free float; a mere handful of them are traded on a daily basis,” said Oliver Belfitt-Nash, former head of research at Monet Capital. “Should the new securities law be passed, many companies would have to delist, but those remaining would have to meet higher standards, offering a clearer view for investors.”

Current regulations make it hard for the FRC to force firms to delist. The move to a closed joint-stock structure is complex given the need for valuation and proper compensation to shareholders, which many owners have resisted. Under the new law, the FRC will gain more power to force firms to valuate. While authorities have refused to say how many stocks they expect delisted, private brokers speak of hundreds of firms overall. The aim is to promote free floats of 25% on average, with 20 major stocks emerging as the largest capitalisations on the exchange within five years of the law’s passing. The top 20 shares already accounted for 86% of market capitalisation in 2011, according to the MSE.

Promoting new listings will be key, especially given the track record of a mere 14 IPOs and six secondary offerings. The new rules will remove the requirement that companies listed on the MSE be incorporated in Mongolia, and will allow for dual listings while reducing fees and complex procedures to list. The exchange established a business development division in 2012 to build a pipeline of new issues, while new underwriters like TDB Capital are now competing with local stock brokerage firm BDS ec. Using the roughly 50 Mongolia-linked firms listed offshore as a proxy for pent-up demand, the MSE sees potential for $45bn for total market capitalisation in the next 15 years. A mining law clause requiring strategic miners to list part of their shares domestically should expand the exchange.

LIQUIDITY, FOREIGN & LOCAL: A total of 20 laws will need to pass or be amended, according to the FRC. Work has already been completed on roughly two-thirds of these and could be passed immediately, according to the FRC. These include financial information disclosure requirements and stronger enforcement powers for the FRC. Distinguishing between beneficial and registered owners, the new rules include a custody law allowing institutions to hold securities on behalf of investors. Provisions for dual listings aim to attract foreign-listed firms with Mongolian operations to the MSE, while firms will also find clear rules for share splitting and mergers and acquisitions. The draft allows for listing up to 90% of either shares or depository receipts offshore, allowing Mongolian corporates to raise more capital and visibility abroad. The lifting of the ban on insurance firms and pension funds investing in listed equities will also follow. The remaining third of laws to be passed, such as rules on derivatives, will require more assistance from foreign advisors, says the FRC.

Foreign investors require local custodians to hold domestic securities they trade: the dearth of custodians and sub-custodians has made investing complex and relatively untested for foreign portfolio investors not placing their capital directly in Mongolian banks. ING pioneered the practice when it opened its representative office in 2008. Buying roughly a quarter of the government’s tugrik-denominated bonds in 2011, the Dutch bank holds them in the Mongolian Securities Clearing House and Central Depository (MSCH&CD), selling units in a offshore trust to investors seeking exposure to sovereign domestic debt. In February 2012 France’s BNP Paribas established ad-hoc custody for China’s second-largest asset manager, Harvest Global Investments, with BNP managing Harvest’s account at the MSCH&CD. Recently introduced rules will permit institutions to manage funds on behalf of clients, which allows global custodians to establish a branch locally or find a sub-custodian. This will also allow custodians to issue depository receipts – instruments carrying rights in the underlying securities – on both Mongolian and foreign exchanges.

With banks making up 95% of financial assets, according to the FRC, creating domestic institutional investors will also be key. So long as legislation on private pension remains pending, the public pension fund not professionally managed and insurance premium incomes low, development of domestic capital will be gradual. Yet underwriters are expected to allocate up to 10% of assets to equities in coming years, while a new pension law is anticipated to reform the public system and provide for private pensions administrators.

REGULATED INNOVATION: Development of sophisticated instruments like derivatives and exchange-traded funds (ETFs) is expected over the medium term. The FRC plans to introduce futures and options first, and ETFs at a later stage. A new investment fund law expected to pass by year-end 2013 at the earliest is a necessary step. While required for onshore creation of ETFs, structured fund managers argue that ambiguities in the tax law will need to be clarified before structured funds are viable onshore. Derivatives warrants will be in increasing demand moving forward, as would the ability to hedge currency risk. With only a spot market and virtually no inter-bank market, other instruments for risk hedging are needed. Given the erratic nature of the foreign exchange spot price centred on the BoM, market players are unable to hedge their risk, while the Ulaanbaatar bank offered rate remains a theoretical pricing instrument and not traded. The significant currency mismatch in Mongolia’s commodity- and dollar-dependent corporate sector reflects the pent-up demand for currency hedging products. The latest draft of the securities law had no mention of market makers however, which along with securities’ borrowing and lending is a necessary condition for such contracts.

While the law will give the FRC more powers to coerce market participants, its technical and financial capacity to police the sector must be improved and penalties for infringement strengthened. Although the FRC fined 20 companies in February 2012 for inadequate financial reporting, the fine was a mere MNT250,000 ($175). A successful insider trading prosecution in 2011 fined two directors of the same company MNT50,000 ($35). In addition to leaving a black mark on individuals’ records, this burdens investors operating in other markets where they would have to disclose such a history. While passing the legislation is highly anticipated, proper implementation and enforcement will be just as crucial in developing Mongolia’s capital markets.