Several innovations in the pipeline to deepen Bahrain's capital markets

The region’s exchanges have operated in adverse economic conditions since the decline of oil prices began in the second half of 2014, and the Bahrain Bourse (BHB) is no exception. However, the apparent stabilisation of global oil prices in 2016 has brought a similar firming of the main index and, after a year of shrinking stock prices, some increasingly attractive valuations.

The larger story of 2016, however, has been of some important structural advances, such as the introduction of real estate investment trusts (REITs) and the emergence of a vibrant secondary debt market. More legislative and infrastructural developments due in 2017 promise to sustain this forward momentum.

EARLY STEPS: Bahrain might have been a trading hub for centuries, but the genesis of its capital markets can be pinpointed to 1957, with the establishment of the first public shareholding company in the kingdom. As personal wealth rose on the back of an oil boom over the next two decades, a growing number of public companies became popular destinations for investment capital. The arena for this activity was an unofficial market known as Al Jowhara, which by the late 1970s was a centre of heated trading activity and, as higher oil prices fuelled an investment boom, increasingly overpriced stocks. The end came in 1982, when the bursting of an equities bubble in Kuwait’s informal stock market, the Souk Al Manakh, triggered a regional domino effect which brought down Al Jowhara, prompting the authorities to step in and formalise the market.

The government then worked with the International Finance Corporation to prepare a feasibility study for an official exchange in the country, the result of which was the establishment in 1987 of the Bahrain Stock Exchange. By 1989 total of 29 companies had listed on the exchange, which at that time was a single-product platform trading equities on a manual system. In 1999 this inefficient process was replaced by an automated trading system, an important step in modernising the bourse. This was soon followed by an equally-significant regulatory shift in 2002, when the Ministry of Commerce relinquished its responsibility over the exchange to the Central Bank of Bahrain (CBB), which regulates its activities to this day. Since then the CBB has worked with the management of the exchange to transform it from a simple platform for the trading of common shares into a multi-product arena 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 Bahrain Financial Harbour and rebranding itself from the Bahrain Stock Exchange to the BHB.

MODERN MARKET: According to the BHB’s 2016 Annual Trading Bulletin, at the end of 2016 the BHB was home to 44 listed companies distributed across a number of defined sectors: commercial banks, investment, services, insurance, industrial, and hotels and tourism. Financial institutions feature prominently on the exchange, a reflection of Bahrain’s status as a regional hub for commercial and investment banking, insurance and financial services. Seven commercial banks, including the National Bank of Bahrain and Bahrain Islamic Bank, made up the single largest sector on the exchange in 2016, accounting for 48.5% of total market capitalisation, according to BHB data. Eleven investment companies formed the second-largest group (26.4%), which includes local conventional and sharia-compliant firms such as Al Baraka Banking Group, Investcorp Bank and United Gulf Bank, that have chosen Manama as a well-regulated base from which to seek investment opportunities in the region. In 2016 the services sector accounted for 13.9% of market capitalisation, and was made up of 10 companies engaged in activities as varied as car parks, cinemas and mobile telecommunications, including Bahrain Telecommunications Company and Zain Bahrain. With 6.5% of market capitalisation, the industrial sector is the fourth largest in the BHB, although there are only three listings within it, one of which is Alba – one of the largest aluminium smelters in the world. The five leisure companies that make up the BHB’s hotels and tourism sector accounted in 2016 for 2.7% of market capitalisation, while the insurance sector was the smallest in the market, with 1.9% of market capitalisation. The latter nonetheless contains some of the financial sector’s most high-profile local companies, such as Al Ahlia Insurance Company and Arab Insurance Group, which have contributed to Bahrain’s reputation as the Gulf’s insurance and reinsurance centre.

FUND CENTRE: Beyond the bourse’s core activity of equity listing, mutual funds represent one of the most active areas of the market, having grown rapidly in popularity since formal regulations governing them were introduced in 1992. Bahrain is the third-biggest mutual fund market in the GCC, according to accounting firm EY, with $1.3bn in assets managed from the kingdom. This asset class is popular across the GCC due to the ability of active fund managers to exploit inefficiencies in emerging markets, and thereby provide healthy returns that outperform market indices. The three largest mutual fund managers in the country are Lebanon’s Blominvest Bank, which has $372m assets under management (AUM), Kuwait’s Global Investment House ($235m) and the GIC Funds Company ($234).

Bahrain’s fund managers operate instruments targeting a wide range of geographies and asset classes, but the local market stands out from its peers as one in which almost half of AUM is directed to fixed-income funds, compared to a regional average of 6%. While the majority of fund activity takes place off the exchange, the BHB had a total of 19 mutual funds listed as of the end of 2016, all of them open-ended. Global Investment House is the largest player in this segment, with five funds traded on the market, followed by the Securities & Investment Company, one of the most prominent financial instructions in the kingdom, and one which is associated with numerous market innovations. Other key fund issuers who have chosen to list their products on the BHB include the National Bank of Kuwait and the Makaseb Fund Company.

DEBT PLATFORM: Among the most significant advances made by the BHB in recent years is the development of its debt market. Debt issuance in Bahrain has historically been of little interest to non-institutional investors; government debt is secured by local banks almost on an allocation basis and held to term, with no secondary market activity at all. An attempt by the CBB to alter the dynamic of this segment by requiring banks to make 20% of the government debt they purchased available to retail investors had little effect, because retail clients were not offered beneficial ownership. Seeking to spur secondary market activity in Bahrain, the BHB worked with the CBB to establish a framework by which investors can gain direct, beneficial access to primary government bond issuances. Announced in January 2015, the mechanism is the first of its kind in the Middle East, and allows individuals and institutions – Bahraini and non-Bahraini – to directly subscribe to government issuances through registered brokers, and thereafter trade the bonds on the secondary market at the BHB. The exchange has placed an emphasis on attracting retail investors to the secondary debt market – for instance by specifying 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 the end of 2016, 14 bonds and sukuk were listed on the BHB, with fixed annual rates ranging from 2.75% to 8.25%. The implementation of the system represents a significant broadening of exchange activity, and provides a useful route to yield for the investment community while allowing them to directly contribute to the government’s infrastructure projects.

In effect, that BHB has developed a secondary debt market in the space of a year, after existing for a quarter of a century without one – a feat which has brought other regional exchanges to the bourse with a view to replicating its success.

In January 2016 the BHB followed up on its success with sovereign bonds by establishing a secondary treasury bills market, a useful tool for banks managing short-term liquidity which had been requested by regional lenders operating in the kingdom. On the first day of the new market 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.

TRACKING THE BOURSE: As the BHB develops in terms of market depth and complexity, so too do the means by which investors are able to track its movements. A range of indices follow the increasingly wide variety of market segments. The most recent of these was introduced in September 2015. The Bahrain Islamic Index is a standardised tool which tracks BHB’s sharia-compliant stocks, and comes as part of Bahrain’s effort to establish itself as the leading regional hub for the provision of sharia-compliant financial services (see Islamic Financial Services chapter). The index included 17 sharia-compliant companies at its commencement.

The predominance of conventional equities trading on the exchange, however, means that the principal tracking tool of the BHB is the Bahrain All Share Index. The bourse’s benchmark index includes all actively traded companies and was first formulated in 2004, but it has since been joined by two other main indices which provide an overview of total market direction. The first of them, the Esterad Index, was established in 2005, and was the first privately administered tracker on the bourse. Owned by a local investment firm which is itself a listed company, the index tracks the price movements of 25 BHB-listed companies. The Dow Jones Bahrain Index was also established in 2005, created in partnership with the BHB to provide a tracking instrument to represent all companies domiciled and headquartered in Bahrain whose stocks trade on the bourse. This index – of variable component number, and full market capitalisation – is reviewed quarterly, and uses the proprietary Dow Jones sector classification system. This differs significantly to the BHB’s sector structure, and thus allows participants to view the bourse in an alternative fashion. Lastly, aside from the three main indices, the BHB provides six minor indices made up of the components of each market sector.

EXCHANGE REGULATION: The proliferation of products and services on the BHB has been aided by the prudent yet flexible approach adopted by both the BHB management and the regulator. The CBB assumed regulatory responsibility for the exchange in 2006, and since that time it has cooperated with the exchange’s authorities to ensure that the market is governed by one of the most advanced regulatory frameworks in the region. Its 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, and it regulates the interactions of these bodies through the flexible tool that is the CBB Rulebook.

Bahrain is the only jurisdiction in the region to operate a unitary regulatory approach, but the internal structure of the CBB means that in effect its operation is similar in nature to the more common multi-agency regulatory framework. 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 aegis of a dedicated body, CBB’s Capital Market’s Supervision Directorate (CMSD). Recent years have seen the CMSD release the nation’s first codified takeovers, mergers and acquisition module, incorporate robust corporate governance regulations into the rulebook, and update its offering of securities regulation – this last had previously been dispersed over a number of documents and circulars. Combined, these initiatives have significantly enhanced the relationship between the bourse and its listed companies. “Bahrain’s legal framework is far ahead of any other in the Gulf,” Stephen Vineburg, CEO of local asset management firm ASMA Capital Partners, told OBG. “The CBB’s open-door policy enables us to have an effect on that policy in the ongoing development of the market.”

PERFORMANCE: Bahrain’s open economy and interconnectedness with the region and beyond is one of the kingdom’s economic strengths, but it also means that the BHB has been subject to the global and regional economic vicissitudes of recent years. This has resulted in market movements broadly in line with the GCC trend. A sustained period of growth in terms of market capitalisation from 2002 peaked in 2007 at $10.19bn, before falling off to $6.1bn in 2009 as the effects of the global financial crisis took hold. A modest rally in 2010 saw market capitalisation increase to $7.57bn, but the domestic and regional political unrest in 2011 resulted in a decrease in value to $6.25bn by the end of the year – with the Bahrain All Share Index falling by 20.15%, according to figures from the BHB and Global Investment House. While declines were recorded across the bourse, the investment index posted the largest decrease, at 28.8%, by followed by the industrial index (-26.7%). A strong recovery began in early 2014, with the Bahrain All Share Index rising from 1,247.98 on January 2 to close the year at 1,426.57, an increase of 14.23%. Encouragingly, the year also saw an increase in both traded value (up 19.2% year-on-year, y-o-y) and number of transactions (up 14.2%).

The precipitous drop in international oil prices, which began in the second half of 2014, resulted in a negative trend for the Bahrain All Share Index, which persisted into 2016, as investors adopted defensive strategies despite the strong performance of the majority of public shareholding companies listed on the exchange. The main index decreased by 14.8% in 2015, and the year was characterised by declining trade activity – with the value of shares exchanging hands down 59.2% y-o-y.

The market capitalisation of the BHB declined by 13.5% over the year, with the industrial sector experiencing the largest fall, at 27.1%, followed by the investment sector at 24.9%. In 2016, the main index stabilised into a broadly sideways trend from the second quarter, showing a year-on-year increase of 0.38% at the close of the year – a move that demonstrated the market’s correlation with oil price, which investors also interpreted as having stabilised.

DEVELOPING THE BOURSE: The exchange authorities, however, are more concerned with the long-term development of the exchange rather than short-term index movements. As with other exchanges in the region, the principal challenge for the BHB is attracting liquidity to the Manama market. The GCC is home large volumes of investment capital, held not only by institutions but also by the region’s high-net-worth individuals. The McKinsey Global Wealth Management Survey estimates that personal financial wealth in the four richest GCC countries amounted to $2.7trn in 2015, up from $1.6trn in 2011. EY suggests that with the inclusion of Oman and Bahrain this figure is likely closer to $3trn, which is similar to the level of investment by the region’s sovereign wealth funds, and several times greater than the amount held by GCC pension funds. The 2015 BCG annual wealth survey found that the GCC countries were all in the top-15 countries worldwide in terms of the proportion of households with over $1m in personal financial wealth – with Bahrain and Qatar in second and third place, respectively. Developing the bourse in such a way at to attract this capital is a strategic priority for the exchange, an effort which takes the form of continuous legislative and infrastructural enhancements. This has included the 2015 implementation of a clearing, settlement and depository electronic registry, the activation of the secondary debt market, the new Islamic index and the introduction of REITs, which are popular with investors worldwide (see analysis).

In terms of boosting liquidity, the three most significant innovations that have taken place over the past year have included establishing a minimum float requirement in order to make stocks more appealing as investment instruments; introducing market making regulations to ensure a continuous balance between supply and demand in the market; and establishing a $100m liquidity fund with four of Bahrain’s most prominent institutions as seed investors (see analysis).

Improving the exchange’s infrastructure and regulatory framework is an ongoing process, which a recent organisational change may help to further. In 2016 responsibility for the BHB moved from the Ministry of Finance to the Ministry of Commerce. While this reorganisation is a relatively minor change – the exchange was previously managed by the Ministry of Commerce from 1989 to 2001, followed by the CBB and then the Ministry of Finance – the fact that the Ministry of Commerce is responsible for the Commercial Companies Law, which is central to BHB operations, means the move represents a useful harmonisation.

OUTLOOK: The BHB has numerous innovations in the pipeline that promise to further deepen the market and attract new liquidity. In October 2016 the BHB obtained permission from the CBB for its new investment market rules, which paves the way for the exchange to open its much-anticipated new market for small to mid-cap companies, the Bahrain Investment Market. The initiative chimes with the government’s more general drive to boost activity of small and medium-sized enterprises in the kingdom, and the BHB has worked with developmental organisations such as Tamkeen and the Bahrain Development Bank to bring this about. Like other secondary markets, the BIM will feature less-onerous listing requirements, such as a lower minimum capital limit, in a bid to attract growing companies. Other market innovations in the pipeline include exchange-traded funds, which like REITs have proved popular with investors in developed markets; margin trading, which will allow investors to borrow funds from brokers to purchase stocks; and short selling.

In addition, structural changes are a possibility in 2017. The BHB and CBB are exploring the possibility of spinning off the settlement operations of the exchange to form an independent settlement bank, licensed by the CBB, that will be able not just to serve listed companies, but also to provide registry services for unlisted companies in Bahrain and, potentially, the region.