Key reforms to Mongolia's capital markets regulation promise better days ahead

The capital markets in Mongolia have benefitted of late from a series of positive reforms, key hirings and the introduction of new legislation. Together, these measures promise to help breathe life back into the country’s stocks and bonds. After almost four years of declining equity prices, more than half a decade with virtually no initial public offerings (IPOs) and weak-to-non-existent demand for Mongolia’s foreign currency bonds at present, serious efforts are under way to attract investors.

Of course, challenges are expected. Mongolia’s macroeconomic situation makes it a tough sell, and a good deal of trust has been lost after false starts and failed initiatives of the past.

Nevertheless, hope remains. Given Mongolia’s open markets and abundant natural resources, its fundamental value is clear. The sense is that once key problems are tackled – most notably the government’s conflict over Oyu Tolgoi (OT) – the country’s capital markets will boom.

“There is a lot of pent-up demand. Once OT is resolved, the situation will flip in a big way,” said Nick Cousyn, COO of BDS ec, a local brokerage firm. He added that Mongolia is a better bet than most frontier and emerging markets, as its problems are less severe than those found in other competing economies around the world.

From a Solid Foundation

Several key pieces of capital markets legislation have been passed in recent years. The Revised Securities Law came into effect in early 2014, superseding the 2002 Securities Law. Among other things, the revised law will expand the roster of tradable securities in Mongolia (including derivatives and warrants); introduce depositary receipts (both Mongolian and global receipts); allow for dual listings; implement significant disclosure requirements for IPOs; shorten the takeover period for mergers and acquisitions; expand licensing requirements; increase monitorng; and outline new restrictions against insider dealing. Significantly, the law also defines the distinction between beneficial ownership and nominal legal ownership, and introduces custodian banks to the market. This is an important step, as these institutions are necessary if international institutional investors are to buy local shares.

In July 2014 Mongolia’s Financial Regulatory Commission (FRC) issued the Regulation on Custodian Licensing and Custodian Services, setting out the licensing regulations and the operational requirements for a custodian.

According to the new rules, a licensed custodian must be a corporation with no fewer than six employees with at least three years of experience in banking, finance or capital markets; comply with minimum paid-up capital requirements; be registered with appropriate authorities; and have the necessary technical and computing infrastructure in place. Banks acting as custodians must create a special subsidiary for the operation, which must have at least one independent director.

Custodian banks are required to keep their custody and banking operations completely separate, with the staff of the custody section having no other roles at the bank and the section’s records kept entirely apart. The law allows for custody, clearing and settlement activities, and does not specifically prohibit any other custodian-related activities that a financial institution may take on in the future.

Custody Licences

Several such licences have been issued already. In August 2014, Golomt Bank received a custody licence from the FRC, as did the Trade and Development Bank of Mongolia (TDB) in October 2014. TDB signed with the Russian banking software provider Diasoft earlier in the year for the supply of a custody solution.

Other domestic banks have also started discussions with global and regional custodians in order to establish agent banking relationships that would enable them to act on behalf of international clients.

Inveswtment Funds Law

The Law on Investment Funds also came into effect in 2014, followed by the Investment Management Companies Regulations. Although there were already statutes in place that covered fund products – the original Securities Law from 2002 discussed them and relevant regulations had been published by the FRC – considerable detail has been added. The new law and follow-on regulations allow for the establishment of mutual and private funds on a 10-year basis, with the latter designed for more qualified, professional investors, while the former will raise funds from the broader public, from a minimum of 50 investors.

Investment management companies must be licensed and registered with the FRC, which supervises the sector, and have a minimum share capital of MNT100m ($60,000). The law also limits the instruments into which a fund can invest, with mutual funds more limited in scope than private funds. Bonds, stocks, property, gold, currencies and foreign securities are among the instruments permitted. Investment funds must engage custodians for safekeeping assets and records, but custodian and management company fees are capped at 3% of average annual net asset value of the fund.

Forming Partnerships

The Mongolian Stock Exchange (MSE) has taken a series of steps to improve its operations and performance.

In September 2014 it signed an agreement with the London Stock Exchange (LSE) Group to extend the partnership between the two by three years. Following on the original agreement, which was signed in early 2011, the MSE and the LSE concluded a master service agreement that included a $14m contract and the implementation of the latter’s MillenniumIT trading and payments system.

September 2014 also saw the MSE enter into discussions on cooperation with the European Bank for Reconstruction and Development (EBRD) on the back of a broad-ranging memorandum of understanding (MoU) reached in 2013 between the EBRD and the Ministry of Finance (MoF) for assistance with capital markets development.

Another important development for the exchange came in June 2014, when D. Angar took over as CEO and initiated a series of reforms. In July he met with executives and officials from the LSE, LCH.Clearnet, FTSE and the EBRD to discuss the introduction of new products on the exchange and development of the necessary infrastructure. In August 2014 Angar met with Bloomberg to discuss using the company’s platform for the trading of government securities. The minister of finance signed an MoU a month later with Bloomberg to that effect.

Retail Ready

In late 2014 the MSE started the primary trading of government securities for retail investors. Previously, government securities sales had been conducted only by the Bank of Mongolia. The new programme is designed to get the debt of the nation into the hands of a wider range of investors. With a minimum purchase of MNT100,000 ($60), high rates, a sovereign guarantee, weekly auctions, tax-free treatment and short maturities, the products on offer may appeal to institutional investors as well. Starting on November 4, 2014, MNT100bn ($60m) in 12-, 28- and 52-week maturity bills were to be sold. On the first day of trading alone, MNT4.5bn ($2.7m) in 12-week bonds were sold at 15.795%.

The MSE is hoping that the state bond programme will help to lift its fortunes. The sale of government bonds has resulted in an almost immediate jump in total volumes, and the increased turnover alone could generate significant business and interest. In a government securities auction in March 2015, a MNT60bn ($36m) issue of 12-week maturity Treasury bills was oversubscribed by more than 75% with a weighted average yield of 15.435%. Regular bond sales of this nature could provide stable business for the struggling exchange and its intermediaries.

Privatisations

An upcoming wave of privatisations are also expected on the exchange. Entities with planned stock sales include the state carrier, MIAT Mongolian Airlines; Mongol Post; Mongolia Telecom Company; Netcom; and the Shivee Ovoo coal mine, among others. The stock exchange itself is also up for a partial privatisation, with the government willing to reduce its stake in the MSE to 34% and allow investors to assume control of the rest.

According to Angar, having control of the exchange is less important than having it run well and help companies raise capital efficiently. The timetable, he says, is to carry out eight IPOs in one year and have all major listings completed by 2016.

Rough Sailings

Despite the efforts being made to improve the environment, the markets have underperformed of late. Foreign-currency bonds, for example, have had difficulty selling.

In January 2014 TDB successfully listed the country’s first-ever dim sum bond, worth CNY700m ($114m), in Singapore. However, when Mongolia’s long-term sovereign debt rating was lowered from “B+” to “BB-” by Standard & Poor’s in April, international interest weakened. By July, TDB was forced to cancel a five-year dollar bond because of Mongolian as well as macro factors.

Although a few private debt placements were sold to international investors in Mongolia in 2014, neither the country nor its corporations were able to issue any international bonds after January.

The country’s lawmakers recently moved to raise the national debt ceiling from 40% to nearly 60% of GDP for the 2015 fiscal year; however, this cap will gradually decrease each year until it settles at 40% in 2018. The city of Ulaanbaatar announced plans to issue a bond of its own, with the intention of investing the funds in the Emeelt Complex and the Nalaikh and Baganurr industrial parks, among other projects, according to local press.

The equity market has also fallen short of expectations. Liquidity is limited and trade is minimal. In February 2015 the average daily trading volume was MNT64.1m ($38,430) and the average number of trades per day was 46. As of mid-March 2015, the top-20 benchmark index was down by almost 60% from its February 2011 peak.

A Narrow Pipeline

The IPO market has slowed to a trickle in Mongolia. Only two new companies have listed on the exchange during the past six years: ETrans Logistics and Merex. The former listed in 2012, selling 7.7m of its shares in an oversubscribed offering for a total of MNT924m ($554,400), or MNT120 ($0.07) per share. Two years later, in January 2014, Merex sold 26m shares for MNT100 ($0.06) each. By early 2015 Merex shares were trading at MNT90 ($0.05), while E-Trans Logistics shares were down around MNT100 ($0.06).

Several obstacles to greater IPO activity persist. The MillenniumIT system, for example, is not yet capable of processing IPOs, and custody banking is not available at present. While some banks have received licences or acquired the right sort of technology, they are missing important elements of the business, such as key relationships with global custodians. Developing these relationships will pose a challenge, as the international institutions may be averse to the risks posed by Mongolian institutions, which rank no higher than the country’s sovereign debt. Custodians also have to build up capabilities separate from their banking operations, and this will require a significant investment.

Without properly functioning custodian banks, the IPO rush may not happen as soon as the exchange would like. Indeed, it is difficult for international institutions to invest in a market without these structures in place. Until these players are truly open for business and have the requisite agreements with global custodians, or regional sub-custodians, any boost to be expected from the resolution of larger, structural issues may be muted. To that end, the MillenniumIT system needs to be built out and upgraded in order to make the market more attractive to issuers and better reflect the domestic market.

Outlook

The upcoming series of IPOs, particularly that of the MSE, is expected to help. With more capital and expertise, the country’s exchange could serve as a good platform for Mongolian mega-issues to be introduced and listed.

However, the reforms will have to continue. As it stands, the regulatory process could certainly benefit from greater efficiency – there is currently little coordination among the responsible ministries, commissions, offices and departments, and the level of overall regulatory capacity remains inadequate. According to bankers familiar with the sector, bottlenecks continue to discourage listings.

While bringing a few large, headline issues to market will do a lot for the economy, at the same time the system needs to work more smoothly and equitably in order to guarantee access to capital for a wider range of companies. If the focus continues to be placed on the largest or most resource-oriented firms, at the expense of any other IPO candidates, other sectors of the economy could be deprived of the cost-effective funding needed for growth.