Regulatory reforms strengthen Bahrain's capital markets

Despite a challenging investment environment, Bahrain’s exchange showed a relatively strong performance in 2017, with index gains in most sectors. Macroeconomic challenges remain in 2018, but new investment instruments and some significant changes to the exchange’s infrastructure are helping it to maintain its status as one of the most progressively regulated markets in the region – a key asset in the regional competition for investment capital.

RAPID DEVELOPMENT: The kingdom of Bahrain has been a trading hub for centuries, but the modern era of capital markets began with the establishment of its first public shareholding company in 1957. An unofficial market known as Al Jowhara was the crucible for trade for a growing number of public companies over the following decades, during which time the value of trades was driven ever higher by capital generated by a regional oil boom. The kingdom’s first equity bubble burst was in 1982, an event which convinced the government of the need for a formal equities market. Working with the International Finance Corporation, the authorities prepared a feasibility study for an official exchange, the result of which was the establishment of the Bahrain Stock Exchange in 1989, with a total of 29 listed companies. The new market started out as a single-product platform, trading equities using a manual mechanism, but in 1999 the exchange received a major upgrade in the form of an automated trading system.

In 2002 the Ministry of Commerce relinquished its exchange oversight duties to the Central Bank of Bahrain (CBB), which continues to regulate the activity of both the primary and secondary market through its Capital Markets Supervision Directorate (CMSD). The CBB has worked closely with the exchange management to grow the bourse from a simple platform for the trading of common shares to a multi-product market that encompasses popular financial instruments such as preferred shares, bonds, sukuk (Islamic bonds) and mutual funds – some of which Bahrain pioneered in the region. In 2010 the exchange passed through another important stage in its evolution, moving to its new premises in the commercial development Bahrain Financial Harbour and rebranding itself from the Bahrain Stock Exchange to the Bahrain Bourse (BHB).

THE MODERN MARKET: As of February 2018 the BHB listed 43 companies distributed across a number of defined sectors: commercial banks; investment; services; insurance; industrial; and hotels and tourism. Bahrain’s status as a regional financial hub is reflected in the distribution of capital in the market: in January 2018 the commercial banks sector accounted for 49.1% of total market capitalisation, according to BHB data. The sector is home to some of the biggest financial brands in the country, many of which serve the wider region from their Manama base. Ahli United Bank is the biggest company on the exchange in terms of market capitalisation, accounting for 24.5% of the total in January 2018, while the second biggest company on the bourse is the National Bank of Bahrain with 10%.

The second-largest group consists of 11 investment companies, claiming 25.3% of market capitalisation, including the conventional and sharia-compliant firms Al Baraka Banking Group, Investcorp Bank and United Gulf Bank, which have chosen Manama as a well-regulated base from which to seek investment opportunities in the region. The services sector accounted for 10.5% of market capitalisation, and is made up of 10 companies engaged in a wide range of economic activities, including car park management, cinemas and leisure complexes, and mobile telecommunications. The three listings in the industrial sector accounted for 11.1% of total market capitalisation, and include Aluminium Bahrain, one of the largest aluminium smelters in the world and a flagship company of the kingdom’s non-oil economy. The four companies that make up the BHB’s hotels and tourism sector accounted for 2% of market capitalisation, while the insurance sector made up 1.9%. Despite being the smallest in the market, the insurance industry comprises some of the most high-profile local companies, such as the Arab Insurance Group, which has contributed to Bahrain’s reputation as a regional centre for insurance and reinsurance.

DEBT PLATFORM: While the BHB remains primarily an equities arena, the exchange authorities have made strenuous efforts to develop a secondary debt market on its platform. In January 2015 it launched a new mechanism, developed in conjunction with the CBB, by which retail investors are granted direct access to government debt issuances – an activity which was previously dominated by the institutional segment, with local banks purchasing government debt almost on an allocation basis and holding it to term. At its launch the mechanism was the first of its kind in the Middle East. Its most important function is to allow individuals and institutions, Bahraini and non-Bahraini, to purchase government issuances through registered brokers, and thereafter trade the bonds on the secondary market at the BHB. The participation of retail investors, in particular, has been encouraged by the imposition a low minimum subscription rate of BD500 ($1330), or 500 bonds or sukuk issued at a par value of BD1 ($2.65) each.

As of December 2017 there were 13 bonds and sukuk listed on the BHB, with fixed annual rates ranging from 3% to 8.25%. The listing and trading of government bonds on the exchange’s secondary debt market represents a significant deepening of the BHB’s activity, and provides a useful route to yield for the investment community while allowing them to directly contribute to the government’s infrastructure projects.

A year after the mechanism’s launch the exchange authorities introduced another innovation by implementing the Treasury Bills Market on January 31, 2016, adding further momentum to secondary debt trade on the bourse. The new market provides a useful platform for banks managing short-term liquidity, something which had, for some time, been requested by regional lenders operating in the kingdom. On the market’s first day the BHB listed 10 Treasury bills worth BD542m ($1.4bn), with interest rates ranging from 1.86% to 2.14% and tenors from three to six months. By February 2018 the number of Treasury bills being traded decreased to six, with total worth of BD406m ($1.1bn) issued by the CBB with discount rates ranging between 3.09% and 3.71% for three to 12 months.

Looking to the wider debt market, which includes the primary issuances by the sovereign and corporates entities not listed on the BHB, the coming years are likely to see increased activity due to the evolving macroeconomic landscape. Bond and sukuk issuances by GCC governments and corporates ran at relatively modest levels up to 2014, averaging $23bn annually, or 1.5% of GDP. However, the need for regional governments to raise funds to offset the effect of lower oil prices on revenue income has led to a rapid expansion in sovereign issuance. From the beginning of 2015 to the first quarter of 2017 the annual average of bond and sukuk issuances more than doubled to $57bn, with sovereigns accounting for the bulk of the rise. Corporate debt issuance is also gathering momentum: in 2016 the GCC’s corporate offerings accounted for approximately 16% of emerging market external corporate debt, according data from US-based global investment firm Franklin Templeton, which is more than that of Latin America or emerging Europe. The increased activity is serving the dual function of drawing the attention of global investors to the region and allowing them to price country risk, resulting in a yield curve against which GCC corporates can price their own instruments in the market.

FUND CENTRE: Bahrain’s reputation as one of the most progressively regulated financial centres in the region has helped the kingdom to establish itself as an attractive destination for domiciling funds. Mutual fund activity has grown rapidly since formal regulations concerning it were introduced in 1992.

In terms of assets under management Bahrain is the fourth-biggest mutual fund market in the GCC, according to Manama-based investment firm SICO, with approximately $570m being controlled from the kingdom. The bulk of this capital, around $443m, is directed towards equities, with approximately $109m allocated to bond-focused funds and $18m channelled to other investment instruments.

Mutual funds flourished in the GCC over recent decades due to the ability of active fund managers to exploit inefficiencies in emerging markets, and thereby provide healthy returns that outperform market indices. In Bahrain, companies such as Lebanon’s Blominvest Bank, Kuwait’s Global Investment House and the Gulf Investment Corporation have capitalised on this trend to establish themselves as leading asset managers in the domestic market. While the majority of fund activity takes place off the exchange, the BHB has succeeded in listing 19 mutual funds as of December 2017, all but one of them open-ended. Global Investment House is the largest player in this segment, with seven funds traded on the market, followed by SICO, one of the most prominent financial instructions in the kingdom, and one which is associated with numerous market innovations. Additional fund issuers that have chosen to list their products on the BHB include the National Bank of Kuwait, the Makaseb Fund Company and the Islamic Development Bank.

As well as mutual funds, Bahrain’s strong regulatory framework, large financial labour market and relatively low operational costs have helped to establish it as a useful base for private equity funds. Given the low deal flow emerging from the small domestic economy, private equity funds administered from Manama generally target other markets in the region, particularly the opportunities emerging from the significantly larger economy of Saudi Arabia. Some private equity players have, however, found useful opportunities in the domestic market. The Manama-based sharia-compliant investment firm Arcapita, for example, had developed a portfolio of utilities projects, including a large district cooling development in Bahrain.

TOOLBOX: Exchanges around the GCC have placed particular emphasis on providing tools by which investors can obtain a clear view of market activity – an ability which is considered central to attracting new liquidity and ensuring market stability. Bahrain’s increasingly complex market is well served by a number of indices, the principal tracking tool being the Bahrain All Share Index, which includes all actively traded companies and was first formulated in 2004.

In 2015, as part of its drive to enhance the BHB’s status as a platform for Islamic financial market activity, the BHB introduced the Bahrain Islamic Index, a standardised tool that tracks BHB stocks compliant with sharia. The index included 17 sharia-compliant companies at its commencement, and by February 2017 it was tracking 14 listings, including domestically important players such as Islamic insurance company Takaful International, Al Baraka Banking Group and telecommunications firm Zain.

The BHB has also struck a number of deals with global and regional market information companies to distribute data packages, which include real-time market coverage, historical and end-of-day data, corporate actions, issuer information and website tickers. Licensees as of early 2018 include Bloomberg, Morgan Stanley Capital International, Osool Asset Management, SIX Financial Information and Thompson Reuters.

PERFORMANCE: Bahrain has one of the most open economies in the MENA region, which means that the performance of the BHB is greatly influenced by regional and global economic forces. The expansion of the bourse over the years has been broadly in line with the wider GCC trend: an extended period of rising market capitalisation from 2002 peaked in 2007 at $10.2bn, before falling off to $6.1bn in 2009 as the effects of the global economic crisis were felt across the region. A short rally in 2010 saw market capitalisation increase to $7.6bn, but the domestic and regional political unrest in 2011 resulted in a retrenchment of market value to $6.3bn by the close of the year, with the Bahrain All Share Index falling by 20.15%, according to figures from the BHB and Global Investment House.

A strong recovery began in early 2014, with the Bahrain All Share Index rising from 1247.98 on January 2, to close the year at 1426.57, an increase of 14.23%. Encouragingly, the year also saw an increase of 19.24% in traded value and a rise of 14.23% in the number of transactions. However, the drop in oil prices in the second half of 2014 resulted in a negative trend for the index, which persisted into 2016 as investors adopted defensive strategies, with the main index decreasing by 14.77% in 2015. In 2016 the main index stabilised into a broadly sideways trend, from the second quarter to the third quarter, before beginning a rising trend towards the end of the year, which continued into 2017.

According to BHB data, the Bahrain All Share Index increased by 191.67 points, or 17.14%, between June 2016 and June 2017. In mid-2017 the market capitalisation of the BHB was 16.9% higher year-on-year, and in February 2018 the index stood at 1351.81. The biggest year-on-year gains were made by the industrial sector, which grew by 61%, followed by investment (23.2%), commercial banks (18.8%) and insurance (4.6%). Hotels and tourism, and services showed modest contractions of -16.1% and -8.4%, respectively. In June 2017 the overall price-earnings ratio (P/E ratio) for the stock market stood at 9.5, an increase on the 8.9 attained in December 2016 and the 8.4 in June 2016. All sectors showed progress in their P/E ratio compared to their June 2016 levels, with the exception of hotel and tourism, which declined from a P/E of 11.8 to 7.6 over the year.

REGULATION: Key to the future growth of the BHB is its reputation as one of the most well-governed exchanges in the region. The CBB assumed regulatory responsibility for the exchange in 2006, and since that time the capital market has been under the regulatory and supervisory oversight of the CBB’s CMSD. The central bank’s oversight of the wider financial sector means that it is able to monitor all market participants, including conventional and Islamic banks, insurance companies, investment firms and brokers. While Bahrain is the only jurisdiction in the region to operate a unitary regulatory approach, the modular structure of the CBB Rulebook allows it to address financial sector issues in much the same was as a multi-agency regulatory framework would. The activities of Bahrain’s capital markets are addressed in Volume 6 of the rulebook, the development of which began in 2008 and continues under the direction of the CMSD. The CMSD works closely with the exchange authorities to ensure that the regulations keep pace with global and regional developments. Since 2012 the kingdom has seen its first codified takeovers, mergers and acquisition module; the implementation of robust corporate governance regulations into the rulebook; and the updating of its offering of securities regulation, which had previously been dispersed over a number of documents and circulars.

MARKET MAKER: More recently, the regulator and the BHB have cooperated to establish a market-making framework, which is an important advance in an ongoing effort to boost exchange liquidity. Market makers are useful liquidity boosters in that they assume the risk of holding a certain number of shares in a particular stock, establish bid and ask prices, and then make transactions with their customers at these rates, taking the opposite side of the trade.

In April 2016 the BHB issued a consultation paper on the matter, and in May 2016 SICO signed an agreement with the bourse which granted it approval to act as the first market maker in the exchange. In March 2017 the BHB issued its market-making guidelines, which include the operational and technical requirements for market makers, addressing core areas such as making bid and offer quotations, and ensuring continuous liquidity on a specified security or group of securities. The new guidelines also establish the legal, administrative, financial, technical and accounting requirements that must be met by market-making companies.

DEVELOPING THE BOURSE: Meanwhile, exchanges across the region are developing products and services while also enhancing market processes in an attempt to attract fresh capital to their platforms. The Bahraini bourse operates in an increasingly competitive environment, and therefore the introduction of new instruments and the continued development of the regulatory framework are key strategic priorities.

One of the most important innovations in this regard was the 2015 introduction of listing and trading guidelines for public real estate investment trusts (REITs). The instruments, which trade on the exchange like ordinary stocks, grant investors access to ownership in large real estate projects at low ticket sizes, and have proved popular with both retail investors and property developers across the region. REIT structures are regulated by the central bank, which has sought to ensure the sustainability of the new instrument by stipulating that the dividend payout ratio must be at least 90% of its net realised income, which is the same requirement imposed on REITs in the UK.

All REITs listed on the BHB must secure approval from the central bank, and thereafter are subject to the relevant legislation in the CBB Rulebook, as well as to the REIT listing rules issued by the BHB. The regulatory framework allows listed REITs to be based on both domestic and foreign property investments, but applies a number of prudential conditions to them. For example, at least 80% of a REIT’s net asset value (NAV) must be derived from a property rental business consisting of at least two properties (with separate title deeds) with a minimum valuation of $20m. Furthermore, development property must not exceed 20% of the REIT’s NAV. The maximum leverage ratio, meanwhile, is restricted to 60% of the REIT’s NAV.

In October 2016 Bahrain’s Eskan Bank announced that it had received authorisation from the CBB to establish and register the kingdom’s first public REIT, which was followed by an initial public offering (IPO) for the instrument, arranged by SICO, and a listing on the BHB. Eskan’s REIT is a sharia-compliant product based on two income-generating and unleveraged properties: the commercial components of Danaat Al Madina, a mixed-use property development in Isa Town; and Segaya Plaza, a mixed retail and residential property located in the Segaya neighbourhood in Manama.

NEW DEPOSITORY SYSTEM: As well as developing new products, the BHB has made some important changes to the exchange’s infrastructure, most notably the creation of a new depository system. Boosting the transparency and integrity of central securities depositories (CSDs) – the bodies which hold stocks and other instruments so that ownership can be transferred without the need to exchange physical certificates – is a common theme across emerging markets. In Bahrain, the process has been undertaken over a number of years. By 2016 the BHB had completed the process of converting all the listed companies on the exchange from paper certificates to electronic records held by the CSD, an accomplishment which earned it a CSD rating upgrade from “A-” (stable) to “AA-” (positive) from Thomas Murray, an international data services firm.

In 2016 the main board issued a resolution to establish the Bahrain Clear Company as a fully owned subsidiary of the BHB. With an initial capital of BD5m ($13.3m), the company began operations in the summer of 2017. The new firm will provide services in the three core areas of settlement, depository of securities and custodians, as well as a range of other services to companies, investors and capital market participants. These extend to processes carried out on behalf of mutual funds, and the provision of custodian services to Bahraini investors in other capital markets and exchanges.

Bahrain Clear seeks to expand the services of the central registry to include the distribution of cash dividends directly to the bank accounts of shareholders, as well as manage the meetings of general assemblies of companies listed on the exchange, including the provision of e-voting. Bahrain Clear will also undertake lending and borrowing in securities and short-selling, and support the margin trading service.

Furthermore, the independent responsibility granted to Bahrain Clear will provide reassurance to sophisticated global investors eyeing opportunities in the local market. The newly established government subsidiary is well positioned to autonomously pursue the continually shifting front line of international CSD best practice – an essential undertaking if it is to maintain, or improve upon, its prudential ratings.

OUTLOOK: Given the economic ties between Bahrain and its regional neighbours, the bourse’s ability to attract new listings and investors is inextricably linked to the wider question of the GCC’s macroeconomic performance. A decline in oil revenue and rising fiscal deficits have resulted in a challenging investment environment since mid-2014.

In late 2017, however, the Organisation of the Petroleum Exporting Countries raised its global oil demand for the third consecutive month, resulting in a more positive outlook for GCC economic growth. Modestly strengthening oil prices and the reform efforts of regional governments are expected to bring about an improvement to fiscal deficits by 2020. However, sovereigns are likely to be compelled to borrow further from capital markets to fund their capital expenditure plans, especially in the areas of infrastructure and energy.

The rising cost of bank credit is also expected to increase capital market activity, as corporates turn to bonds, sukuk and IPOs as a more cost-effective means of funding their expansion. Regulatory changes have the potential to accelerate this growth still further: the Gulf Bond and Sukuk Association revealed in mid-2017 that it is working on a range of innovations aimed at enhancing the market, such as securitisation, hybrid sukuk, green bonds and new sukuk indices. It also intends to strengthen the institutional investor base by promoting pensions and insurance reforms.

Distinguishing itself amid these regional developments will remain a top priority for the Bahraini exchange, a goal that will be met through the continued enhancement of the kingdom’s regulatory framework and creation of new investor-friendly instruments.