Opportunity-risk ratio: Steadily developing the exchange for long-term returns

In many respects, Bahrain’s capital markets offer the variety and depth expected for a financial sector of its type. There are two securities exchanges, a local funds industry growing in size and sophistication, and liquidity management tools in the form of government-debt securities, which are issued on a regular basis. In recent years, the kingdom has attracted more specialised boutique investment firms and funds, and the Central Bank of Bahrain (CBB) has introduced new regulations and approaches. As is often the case in the Gulf, however, the stock market in particular – but securities overall – face a liquidity challenge. The region does not suffer from a lack of capital, and that means fewer firms here need to look at stocks and bonds to finance their operations. The typical disclosure and regulatory requirements are a further disincentive to a public listing or debt issue. In Bahrain’s case, the varied options in the financial sector are deemed attractive and sufficient.

LOCAL CHALLENGES: For the Bahrain Bourse (BHB) and for investors in equities or corporate debt, this sometimes results in the common developing-market issue of an equities list with some attractive companies, but a trading volume insufficient for large-scale portfolio investors like emerging-market mutual funds. With typically smaller stakes of firms listed and trading as free float – in most cases significantly less than a majority stake – a fund with $1bn in assets under management, or even hundreds of millions of dollars, would need to make an equities purchase of $10m or more in order for a stock gain to make a meaningful impact on the fund’s performance. Finding blocks of shares that large in markets with small numbers of stocks trading small in free float is difficult.

Though Bahrain shares these issues with others, the BHB in other ways stands out in a regional context, given that it is a less volatile market. Smaller swings in stock prices mean valued stability for long-term investors, but also lower trading volumes in Bahrain. In the region’s recent history, portfolio investors have bounced from market-to-market, trading in and out of positions in search of the next rally. This rotation of “hot money”, as short-term investment seeking high returns is often called, creates revenue for the exchanges and adds liquidity. However, Bahrain’s approach, underpinned by the prudent regulatory approach of the CBB, is to work toward finding the right balance. Bahraini officials do not want to host a volatile stock market, but one in which investors who wish to can seek short-term returns while also making it possible for long-term buyers to safely park their money in stable securities that offer steady growth. Developing an equities market with healthy fundamentals remains an important goal for the kingdom as outlined in Vision 2030, the country’s long-term economic development strategy document.

MARKET PLAN: The plan for capital markets is at an early phase, and includes overhauled regulation, as well as restructuring the BHB to provide a corporate structure that will allow it to act with greater speed and flexibility. From there, Bahrain’s capital markets will see an increase in the number of instruments available and platforms to trade them on, potential initial public offerings (IPOs) through the government selling stakes in some publicly-owned corporations, and greater options for securities beyond stocks and bonds. The vision is a facilitative and competitive capital markets industry, overseen by a dynamic and prudent regulatory regime.

As such, 2013 will see preparatory steps continue, in addition to changes and incentives with the potential to help boost liquidity. Impact may come from online-trading incentives, for example. “This should be a good incentive to bring smaller investors into the market,” Jithesh Gopi, the head of research for the Securities & Investment Company, a securities-focused investment bank, told OBG. On the debt side, the regular issues of sovereign bonds and sukuks (Islamic bonds) from the CBB could be complemented by commercial banks taking advantage of a trend in sharia-compliant sukuk issuance for the purpose of raising core bank capital, according the new rules of the Basel III standards from the Basel Committee on Banking Supervision.

LEARNING FROM MISTAKES: BHB has been the flagship securities exchange since its creation as the Bahrain Stock Exchange in 1987. It was founded in response to the collapse of the Souk Al Manakh stock market in Kuwait in 1982. Stock trading there had proceeded unregulated, with prices for shell companies, inactive corporations and other on-paper-only entities bid up by investors, who often used post-dated checks to pay for transactions. Most participants in this market were highly leveraged and with few liquid assets, such that a bounced check managed to unravel the whole system. Defaults triggered more defaults by parties unable to cover other transactions, and the problem spread to Bahrain. A similar unregulated exchange in Manama called Al Jowhara found itself exposed to the defaults.

Securities trading as a regulated activity began on the old Bahrain Stock Exchange in 1989, and moved from a manual to an automated system in 1999. In 2010, a new holding structure was established and the market was rebranded. One year later it was converted from a quasi-government agency to a corporation owned by the Ministry of Finance as part of a long-term restructuring and strategic plan. That change is still in the implementation phase. For 2013, the most notable difference may be the increased use of online trading, which has been available since 2007, but is now being promoted through incentives (see analysis).

AVAILABLE OPTIONS: As of mid 2013, there were 48 equities listed on the exchange grouped into nine areas: commercial banking; investment; services; insurance; industry; hotels and tourism; preferred shares; closed companies; and non-Bahraini companies. There were eight debt securities listed; among them six were government issues and one from the International Finance Corporation. The sole corporate bond on the list was a sukuk that matured in 2010 and had been issued by The Investment Dar, a Kuwaiti investment firm. The BHB roster also lists 26 mutual funds, 12 brokers (three individuals and nine firms) and five custodian services. Membership rules currently require that brokers must be Bahrainis or Bahrain-domiciled companies, although foreigners may be allowed to gain membership depending on circumstances. There are at present no foreign members, however, in early 2013 the market expected some in the future as a measure to boost liquidity.

As measured by market capitalisation, BHB is the smallest bourse in the GCC – $16.4bn as of January 13, 2013, accounting for 2.1% of the total regional figure of $769.4bn, according to Global Investment House (GIH), a Kuwaiti investment bank. On the BHB, 149.9m shares were traded on the month worth a total of $40m, up from 34.3m and $10m in the previous month. For 2012 as a whole, the value of all shares traded had risen 5% from 2011 to BD110.2m ($290m), as per a market report from the Bahrain Economic Development Board.

The Bahrain All Share Index is the benchmark for the BHB and ended the first quarter of 2013 at 1091.58 points, in comparison to 2012’s closing of 1065.61, reinforcing the market’s reputation as a stable performer. Shares traded in a tight band all year, as the highest closing level in the period was 1162.19 on May 6, and the low was 1035.3 on December 20, 2012. The services sector recorded the strongest performance among subgroups, climbing 8%. Other indices include the bourse’s sector-specific sub-indices and the Dow Jones Bahrain Index, which also tracks overall market performance. The Bahrain Bourse Esterad Index, managed by the publicly-traded investment firm Esterad Investment, aims to be a selective measure: it contains 22 equities selected by sector representation, market capitalisation and by liquidity. Both the Dow Jones and Esterad indexes indicated a similar 2012 performance to the All Share index. Banks comprise more than half of market share of the BHB, and eight of the top-10 stocks. Ahli United Bank was the largest at the end of January 2013, at a market capitalisation of BD1.18bn ($3.1bn), according to GIH. It was followed by Aluminium Bahrain at BD622m ($1.64bn) and Bahrain Telecommunications (Batelco) at BD604.8m ($1.6bn). The top 10 accounted for almost three-quarters of market.

LOCAL INVOLVEMENT: Participation on the BHB is driven by local Bahraini investors. Typically, just over half of market capitalisation is owned by Bahraini interests, although the 52% level of foreign participation as of February 2013 indicated a capital inflow from outside the kingdom, according to BHB figures. Large institutional investors include the country’s insurance companies and takaful (Islamic insurance) providers, and pension funds such as the Social Insurance Organisation and the Bahrain Pension Fund Authority. The Military Pension Fund has been transferred to the Bahrain Pension Fund Authority for management.

Pension funds and insurance companies could play a central role as institutional investors in the future owing to long-term trends boosting their assets under management. As Bahrain’s job market grows, employers are competing for talent based on salary but also benefits packages, and that is fuelling growth in life insurance policies and pension plans, for which pools of cash are often invested in assets such as stocks. A new pensions-focused company, Takaud Savings & Pensions, has based itself in Bahrain and aims to meet growing demand across the Middle East and North Africa (MENA) region. The company is 50% owned by Kuwait Projects Company, a Kuwaiti investment vehicle, and 50% by United Gulf Bank, and is aiming to launch corporate pension plans followed by products for individuals. “Growing middle classes, increasing levels of awareness, demographic and changing cultural environments are powerful drivers of demand for long-term savings and private pensions products,” Abdallah Kubursi, CEO of Takaud, told Reuters in late 2012. The company’s products will first be offered in Bahrain, and then to Kuwait and Jordan, before a regional presence is established.

DEBT SECURITIES: Five types of government securities are sold via auctions or tenders: treasury bills ( Tbills), government development bonds, and three types of sukuks (see Islamic Financial Services chapter). Tbills with a term of 91 days are sold on a weekly basis, with the total value per auction at BD25m ($65.8m). Notes maturing in 182 days are sold monthly to a total of BD20m ($52.6m), and 364-day bonds quarterly, with the issue amount at BD50m ($131.6m), according to the CBB. These are sold in a variable-rate auction, with domestic retail banks, the Social Insurance Organisation (one of Bahrain’s pension funds) and other central banks as eligible bidders. The CBB selects in line with price and yield offers until the issue has been fully subscribed to. The value of T-bills outstanding as of February 2013 was BD930m ($2.45bn), according to Bahrain Economic Development Board. The outstanding value of government development bonds was BD1.48bn ($3.9bn). These are sold on an ad hoc basis, range in maturity from three to 10 years, and can be denominated in Bahraini dinar or dollars. These are fixed-rate auctions, in which participants do not offer a yield, but specify only a quantity of bonds they are willing to buy. A pro-rata system is used for allotment.

Growth in corporate issues is more likely for sharia-compliant sukuk offerings rather than conventional debt. One potential large offer that did not materialise was from Aluminium Bahrain, which had a $169m bond that matured in March 2013. Instead of rolling that over with another issue it opted for bank financing.

REGULATION: Capital markets participants in Bahrain are regulated according to Volume Six of the CBB Rulebook. The CBB took over regulation of the field in 2002, and is nearing the end of a long process of overhauling the content. To date, 11 of the 14 modules in the volume have been reworked, involving consultation with stakeholders, and part of an effort to provide transparency in regulation. Modules left to overhaul include those for listing, disclosure and training, and competency. The Offering of Securities Module, which was in the consultation process as of late 2012, will have a key regulatory impact over the next few years, and includes prospectus templates for various forms of securities. This should make listing cheaper and easier, as well as encourage more IPOs, to which there have been none since 2011, when there was one.

The CBB has issued 22 capital markets licences, a category that includes brokers, exchanges and facilitative bodies. Investment firsts are licensed in three separate categories in the regulator terms of the investment business sector. This area includes a wide range of activities, such as custodianship and other professional services, but the bulk of the sector is aimed at taking the ample liquidity of the region and channelling it into investments, and the three grades of licences available are calibrated accordingly. Category-1 licence holders are asset managers, who can manage client money and a proprietary-trading account of their own. Category 2 forbids a proprietary-trading account, and Category 3 permits neither, leaving advisory services as the chief activity. There is significant overlap between a Category-1 investment licence and a banking licence in Bahrain, with financial actors from both segments of the industry often essentially doing the same thing. Together, companies in the three categories reported a total of assets under management at some $16.46bn at the end of the third quarter of 2012, up 72.4% year-on-year (y-o-y) from 2011.

Regulation and licensing specifically tailored to these investment companies and to advanced fund types has been developed since 2006. In that time a domestic fund industry has also emerged. Previously the majority of the funds available for investment in Bahrain were created elsewhere and registered in the country, but there are now 120 established by local companies, with custodians, administration, registrars and other bodies all domiciled in the kingdom, according to the CBB.

Investment firms across all categories are expected to group their clients into four categories and offer them products accordingly. The retail investor category is for those with less than $100,000 of invested assets, and these customers are assumed to have a minimal level of financial literacy. Regulations mandate that they be offered investments diversified by instrument, market, sector, geography and otherwise, and that the investment must be easily convertible to cash. From there, a greater level of financial literacy is assumed and restrictions are eased, allowing firms to offer their clients more risk and less diversity. Expert investors are those holding between $100,000 and $1m of invested assets, with a minimum for any single investment being $10,000. The exempt category covers those from $1m to $5m in invested assets, and the private-investor category covers those with more than $5m to invest and a net worth of at least $25m.

NEW PLATFORM: Though the liquidity challenge is common globally, Bahrain’s second exchange, the Bahrain Financial Exchange (BFX), experienced a spike in liquidity in October 2012 that has sustained itself through the early months of 2013, giving this young operation an encouraging start in the kingdom.

The BFX, as it is called, is owned by Financial Technologies (FT) of India Limited, a group that operates bourses in emerging markets, mostly in Asia and Africa. The group received a licence from the CBB to open up a multi-asset exchange, and trading commenced in 2011. However, the bourse has introduced products in reverse of what is typical – it has started with derivatives and has plans to offer trading in stocks and bonds in the future. That may eventually bring it into competition with BHB, and likewise the incumbent market has plans for its future to offer what BFX does now. Trading commenced in the fourth quarter of 2011, with growth picking up in the latter half of 2012. In the first quarter of 2013, roughly 4.5m contracts were traded on the BFX worth some $32.37bn, up from 11,215 contracts valued at $441m in the first quarter of 2012. Volume and value more than doubled from the last quarter of 2012 to the first of 2013.

BFX officials say participation in the exchange is geographically diverse, and one of the main reasons the parent company viewed Bahrain as a favourable location is that it provides a suitable time zone for traders looking to make moves in the hours when bourses in Europe and Asia are open.

Other FT locations outside of India include Singapore, Mauritius, Botswana and Dubai. Each location offers a different mix of products, regulatory features, tax implications and other differences that emerging-market investors use to select where they will place their trades. More than 90% of overall volume came from Indian rupee-US dollar futures contracts, of which several times are offered. The rupee futures appeal to customers in the parent company’s home market of India.

NEW TOOLS: The BFX US dollar versus the Indian Rupee Index Mini Futures is an innovative product that is not traded elsewhere. The BFX USD-INR Index Futures won the “Most Innovative Forex Product” award during the Jordan Forex Expo 2012. The Mini Futures became the largest-traded derivatives contract (in terms of the number of contracts traded) in the MENA region during the first quarter of 2013. The BFX has also launched futures contracts on gold, silver and euro versus the US dollar and natural gas. Recently, the BFX MCX US dollar Gold Futures and the BFX MCX US dollar Silver Futures were introduced. These products are based on the equivalent prices of gold and silver traded on the Indian markets, but are quoted in US dollars.

The futures traded on the BFX markets appeal to a wide section of market participants across the MENA region and Asia mostly due to the narrow bid-ask spread, resulting in lower transaction costs as compared to the over-the-counter markets. The Mini Futures contract facilitates retail participation (each contract has a value of approximately $5400, requiring a margin as low as around $109 per futures contract). The expansion plan for 2013 includes introducing futures and options contracts across various underlying assets, including base metals and equity indices, respectively. The cash segment for equities, bonds, commodities and currencies is expected to commence during 2014.

BFX CEO Arshad Khan cited derivatives as simpler at the start, as they do not require convincing companies to make the decision to list or issue bonds and then spend the money required on a prospectus and disclosure. The case for derivatives is also stronger in the wake of the 2007-08 global financial crisis, he said.

“You can trade derivatives in the futures market on an exchange or on the forward market, which is over the counter, so it is not regulated,” Khan told OBG. “After the crisis we have seen that more people want to move to exchange-based trading. They think that is safer because it offers more transparency,” he added.

The BFX is also offering a sharia-compliant securitisation service to act as a liquidity-management tool for Islamic banks, investment companies and other actors. They typically manage liquidity through transaction in which a financial intermediary buys something, often a commodity, and sells to another financial institution for a higher price, but with payment deferred for an agreed-upon period. The buyer, typically a financial institution needing to manage its cash flow, gets the up-front liquidity it needs this way and its partner profits from providing this service. The BFX proposes to play an intermediary role: once the two sides have agreed on terms, they can use the BFX’s platform to securitise the asset and complete the sale. Bahrain is one of two places worldwide in which this market-based transaction is offered: the other is in Kuala Lumpur, where on Bursa Malaysia palm oil futures are used. The BFX is gradually attracting investors and traders from both the institutional and retail segments. Khan said that the BFX products enable investors to diversify their investment portfolio risk. Investors can also retain their investible funds within the region. The BFX’s offerings in Bahrain also include a training and education component, which it uses to boost interest in the advanced securities offered on its bourse.

OUTLOOK: Though the kingdom’s capital markets are broad and offer multiple options for the various types of investors who rely on them, Bahrain is looking to further develop its securities platforms. Ideas such as a small and medium-sized enterprise list, making BHB membership available to non-Bahraini companies, offering more exotic securities and seeking international partnerships are under consideration, for example (see analysis). The entry of the BFX has served the country’s overall goal of extending the role of financial services as a central pillar of the economy by bringing new firms, licensed by the CBB, to trade on the market and create more employment.

Long-term plans to add dynamism and liquidity to the BHB are roughly along the lines of what has been tried in other emerging markets, but they have been adjusted to fit the kingdom’s sensibilities and reputation. Bahrain is seeking an incremental approach in creating the right balance between opportunity and risk. That combined with the regulatory approach of the CBB, such as prospectus templates and other facilitative efforts, could help create liquidity for the long term.