New instruments and increased foreign involvement set the stage for investment in Saudi Arabia's capital markets

The Saudi Stock Exchange (Tadawul) entered 2019 on the back of a strong year, in which the main index showed the first solid gain since 2016. A raft of reform measures, inclusion in some of the world’s most influential indices and a lengthy roster of initial public offering (IPO) prospects emerging from the Kingdom’s Vision 2030 strategy mean that the near term is likely to be another lively period for the market.

History

The modern era of Saudi Arabia’s capital markets began in the 1930s, when the Arab Automobile Company was established as the Kingdom’s first joint stock company. In the early years of the informal market, trading was limited to a handful of firms, but an oil boom following the Second World War led to a rapid increase in activity, with 14 public corporations establishing themselves in the country by 1977. The authorities decided that it was time for a more formal basis for trading activity in the 1980s and tasked the Ministry of Finance (MoF), the Ministry of Commerce and Industry and the Saudi Arabian Monetary Authority (SAMA) with establishing a proper exchange infrastructure. In 1990 SAMA created Saudi Arabia’s first electronic trading system, known as the Electronic Security Information System, which linked the central bank with 12 central trading units operated by individual banks. This resulted in a more streamlined market, increased trading activity and a narrowing of price spreads.

In October 2001 the exchange implemented a more advanced system capable of handling larger trading volumes which, after more expansions and enhancements, is still in place today. The government introduced the Capital Market Law in 2003, which resulted in the creation of a number of key institutions, including new regulators for the market: the Capital Market Authority (CMA), the Committee for the Resolution of Securities Disputes (CRSD) and the Appeals CRSD. More recently, exchange development has centred on opening up the bourse to non-Saudi participation and bringing standards and processes in line with global best practices. This effort has been rewarded by some of the world’s most influential capital markets intermediaries. The Tadawul announced in mid-2018 that the MSCI, the leading provider of global equity indices, upgraded the Kingdom to an emerging market from its previous status of standalone market. Saudi Arabia, which was also added to the FTSE Russell Emerging Markets Index as a secondary emerging market in 2018, will be included in MSCI’s Emerging Market Index in two phases with the May 2019 Semi-Annual Index Review and the August 2019 Quarterly Index Review. The Kingdom is now the third country in the GCC to be included in the MSCI Emerging Markets Index, and it is by far the largest, with a total market capitalisation of more than $500bn.

Main Market

At the outset of 2019 there were 190 companies listed on the main market of the Tadawul. Since 2017 they have been divided into 20 sectors, defined by the Global Industry Classification Standard, developed by MSCI and S&P Dow Jones Indices, which include allocations such as energy, materials, capital goods, retailing, biotech and life science, real estate investment trusts (REITs), and real estate management and development. While primarily an equity exchange, over the past decade the Tadawul has evolved from its starting point as a single-asset-class platform to include a wider array of financial instruments, starting in 2010 with the addition of an exchange-traded fund (ETF). The first ETF listing in the Kingdom was the Falcom Saudi Equity ETF. It has since been joined in the market by the Falcom Petrochemical and HSBC Saudi 20 ETFs.

Performance

Firming oil prices and the news in June 2017 that the Tadawul was on the MSCI watch list for an upgrade to emerging market status helped make 2018 a positive year for the exchange. The TASI closed the year at 7826.73 points, an 8.31% gain over 2017. Market capitalisation also rose in 2018, gaining around 10% to reach nearly SR1.9trn ($506.7bn). In terms of sectoral activity, media and entertainment showed the highest gain for the year, rising by nearly 32% over 2017, followed by banks (31%) and telecommunication services (27%). The sectors which saw the most retrenchment were real estate management and development (-31%), utilities (-26%) and REITs (-22%).

Parellel Market

The Tadawul and the CMA officially launched Saudi Arabia’s new parallel market, Nomu, in 2017. As in similar markets elsewhere in the world, Nomu offers listing companies a more lenient regulatory regime, and is intended to act as a platform on which smaller firms can raise funds. Consequently, there are a number of important differences in the listing requirements between Nomu and the main board: the minimum market capitalisation is set at just SR10m ($2.7m), compared to SR100m ($26.7m); firms must have an operation history of one year, as opposed to three; quarterly disclosure requirements are slightly longer than on the main board; and the minimum free float is 20% of the company, rather than 30%. As of early 2019 there were 10 listings on Nomu, double the amount at the time of its inauguration. Liquidity on the platform is low compared to the main market, which is often the case with secondary boards. However, liquidity on Nomu has also been impacted by CMA policies that aim to protect investors. For instance, only qualified entities are permitted to invest on the board, including corporations, government-owned companies, GCC funds and firms, investment funds and discretionary portfolio managers, as well as individuals who have at least SR40m ($10.7m) invested on the Tadawul All Share Index (TASI), a portfolio size of over SR10m ($2.7m) or hold the relevant certificates.

Debt Market 

One area that is still in the early stages of development is the bourse’s debt market. The market has been home to an electronic trading platform for conventional bonds and sukuk (Islamic bonds) since 2009, but corporate bond and sukuk listings on the exchange have remained at negligible levels. However, the government has moved to invigorate the market by listing a number of its own debt instruments, with this process completing in 2017. The arrival of these instruments on the exchange has greatly increased offerings available to investors in the secondary market: some 60 of the 65 sukuk listed on the exchange were government debt instruments as of early 2019.

Active in Issuance

The state is also galvanising the Kingdom’s wider debt market through its regular sovereign issuances, which provide a useful yield curve for corporate offerings. In October 2016 Saudi Arabia staged its first international bond sale, attracting $17.5bn in a heavily oversubscribed offering, which is the largest of its kind to come from an emerging market. In April 2017 the country diversified its funding base still further, with the well-received issuance of its first dollar-denominated sukuk – sold in two $4.5bn tranches with tenors of five and 10 years. Since then, the country has emerged as a major regional issuer of debt, having raised $52bn through international notes, both conventional and sukuk, by October 2018. An $11bn bond sale in April 2018 covered most of Saudi Arabia’s hard currency needs for the year, and in September 2018 the government completed its external funding requirements with a $2bn sukuk offering. This is in line with the MoF’s commitment to “the development of the sharia-compliant debt capital markets”, as stated by the Debt Management Office at the time. The Kingdom began 2019 by raising $7.5bn in an international longterm debt issuance that attracted $27bn in orders. In late 2018 the MoF announced intentions to issue around SR32bn ($8.5bn) in further bonds over the coming year. Assuming no repayments, that would bring total government debt to approximately SR678bn ($180.8bn), a comfortable level of around 22% of GDP.

Regulation

The continued development of the exchange is being overseen by the CMA, which is given a broad mandate by the Capital Markets Law, including oversight of security issuance, listing, trading, settlement and regulatory enforcement. Since 2015 one of the body’s chief strategic priorities has been opening the bourse to foreign investment through a qualified foreign investor (QFI) model, which grants direct access to the exchange to a limited number of foreign institutions, such as banks and brokerages.

Since the introduction of the QFI system the CMA has been gradually lowering the minimum criteria for QFIs – most recently in January 2018 when the minimum asset value requirement was lowered from $1bn to $500m. Other such moves have included raising the limit for a single QFI’s stake in one company from 5% to 10%; lifting the threshold for total foreign holdings in a listed entity to 49%; making it easier to register as a QFI through the removal of the requirement to have the CMA’s review and approval; and allowing the automatic qualification of units and managed funds of applicants without the need for separate applications.

Early entrants into the market included some of the world’s most prominent asset management brands, including HSBC Bank, Ashmore Investment Management and Blackrock Fund Advisors. The number of QFIs qualified for investment in the Tadawul grew by 176% over 2016 to reach 47 institutions, and by the close of 2017 a total of 118 foreign financial institutions had registered to trade on the exchange.

Developing the Market 

As well as widening the investor base, the Tadawul and the CMA have been deepening the market through the introduction of products. The Kingdom’s first REIT was issued by Riyad Capital in 2016. Following this, it quickly emerged as a popular investment tool, with yields in excess of 7%. The market leader in the instruments is Jadwa Investment, which launched its first REIT in April 2017 and a second in February 2018. This made it the first firm to list two REITs on the Saudi market and the largest manager of the products in the Kingdom, with more than SR2.3bn ($613.2m) of assets under management. Additionally, in 2017 the Kingdom transitioned to a T+2 settlement cycle for all listed securities – replacing the T+0 framework and aligning the bourse with international best practices – and became the first country in the GCC region to introduce short selling.

Derivatives on Offer

In addition, the exchange is preparing to introduce derivatives trading for the first time in the country. In September 2018 global index provider MSCI announced that it had reached an agreement with the Tadawul to jointly launch a tradeable index. The market index will form the basis for the development of derivatives and futures investment instruments on the Tadawul – widely considered as essential to attract international investors to the market over the long term. According to a Tadawul statement, the exchange will launch its index futures instrument, based on the joint MSCI Tadawul 30 Index, in 2019. The index will thereafter function as a basis for multiple products in the market, a development which will represent a significant deepening of exchange activity – most particularly in the area of hedging and risk management that is a fundamental aspect of sophisticated investment practise.

The arrival of derivatives on the bourse is closely linked to the launch of the exchange’s new Central Counterparty Clearing House (CCP), details of which were revealed in 2018. The CCP, established as a closed joint stock company with a capital of SR600m ($160m), brings a range of functionalities necessary for complex trading instruments. These include netting – the offsetting of the value of multiple positions or payments due to be exchanged between two or more parties – which significantly reduces the number of transactions in complex settlements as well as overhead costs. The CCP will also lower the risk for counterparties to a trade, as it will be the sole contractual counterparty when trading on the Tadawul. The arrival of the CCP is one of the most significant changes in the Tadawul’s post-trade infrastructure over recent years, opening the door to a new era of exchange growth based on a broader range of investment instruments.

Financial Technology

In more recent times the regulator’s efforts to develop the exchange have moved into the rapidly evolving financial technology (fintech) arena. In January 2018 the CMA issued its fintech experimental permit instructions, establishing a regulatory framework for the nurturing the use of fintech within Saudi Arabia’s capital markets, with the regulator receiving its first batch of applications for new experimental permits the following month. By July 2018 the authority had issued its first two fintech licences to Riyadh-based start-ups Manafa Capital and Scopeer – both of which aimed to launch crowdfunding investment services on a trial basis. The model for the platforms allows individual investors to fund small and medium-sized enterprises in exchange for an equity stake in those enterprises. The technology is rapidly growing in popularity in markets worldwide, with new platforms competing for capital across borders.

Financial innovation has emerged as a strategic battleground for global markets keen to attract liquidity. The CMA’s promotion of fintech also speaks to two ambitions of the Kingdom’s reform programme: deepening its capital markets and creating new employment opportunities by supporting entrepreneurs. In October 2018 the regulator welcomed applications for the second batch of fintech experimental permits, stating a priority for those entrepreneurs that aim to “promote growth and efficiency in the capital market”.

IPOs

The regulator has also worked hard to increase the number of listings on the exchange. The Tadawul was ready to receive the Aramco IPO in 2018, slated to be the world’s largest on record. However, after no action was taken by the third quarter of the year, reports of a possible cancellation began to circulate in the international press. The government was quick to deny these rumours, and in late 2018 it was announced that the much anticipated IPO would occur in 2021. The Saudi oil giant is not the only IPO candidate in the region to place its flotation plans on hold. The MENA IPO pipeline slowed in 2018 as global trade concerns, regulatory changes and regional politics combined to dampen IPO sentiment across the Gulf.

In total approximately $2.9bn was raised through IPOs in the MENA region in 2018, representing a 24.6% decline over the 2017 total. Despite this, Saudi Arabia was the IPO leader in the region both in value and volume, raising nearly $1.5bn through 12 offerings. The government’s privatisation programme, a central component of the Kingdom’s ongoing process of economic reform under the Vision 2030 strategy, is likely to generate further IPO activity over the medium term. The National Centre for Privatisation and Public-Private Partnerships has targeted a number of sectors for investment, including water and agriculture; transport; energy, industry and mineral resources; labour and social development; housing; education and health. The government intends to offload between SR35bn ($9.3bn) and SR40bn ($10.7bn) of state assets before 2020, including flour mills, desalination plants and postal services – some of which it will divest itself through an IPO process (see Economy chapter).

Outlook

The MSCI and FTSE Russell upgrades will have a positive effect on the Tadawul’s liquidity. The exchange will benefit from both the passive flows of capital that inclusion on the index entails, as well as the heightened interest from active investors who have been reassured by the process of reform that made the upgrade possible. These factors have led some analysts to foresee an estimated $14bn liquidity injection by the end of 2019 as a result of the development, while other estimates have reached $40bn, taking into account both passive and active flows.

However, more important than the immediate liquidity gain is the longer-term stability that the exchange will enjoy as a result of its broader, more institutional investor base. In the short term it is possible that the regulator’s efforts to open up the exchange, which until now focused on investors, will be extended to issuers. The CMA revealed in 2018 that it was working on regulations that would allow it to open up the market to non-Saudi issuers, either through a dual listing or a direct primary listing. A Saudi listing would likely be of interest to regional corporates looking to tap into the country’s deep pools of disposable wealth, as the Kingdom was home to approximately 176,000 millionaires in 2017 – the highest number in the Middle East.