Taking stock: New regulations and guidelines are aimed at renewing the market

For the Mongolian Stock Exchange (MSE), 2013 was a year of transition. While performance remained weak and trading was exceedingly thin, preparations were being made for a comeback. New systems were introduced, important rules were changed and a new securities law was enacted that should address many of the gaps that previously existed and made the market less attractive to international investors – in some cases even impossible to invest in. The hope is that the foundation has been set to make 2014 a year of recovery for the market.

In 2013 trading dropped off to almost nothing, with volume in the second week of December 2013 at around $24,000 a day. Market capitalisation fell under $1bn, and the MSE Top 20 index dropped 60% between February 2011 and May 2013 – it was the third-worst-performing exchange in 2012 after Cyprus and Ukraine. This came after years as a top performer, and the index had ranked first worldwide in 2010, when it was up 130%. Once identified as the hidden jewel of emerging markets, by early 2013 it getting very little attention from investors and a good deal of criticism.

A Bad Start

Delays and controversy related to Oyo Tolgoi mine, declining investment following the 2012 Strategic Entities Foreign Investment Law (SEFIL), the delayed initial public offering (IPOs) of the Erdenes Tavan Tolgoi (ETT) mine and falling commodity prices have damaged the economy and made the country’s stocks relatively poor bets.

Worse, Mongolia has suffered damage to its reputation. The rapid changes to rules and quick reversal of those same rules, as well as the long-delayed passing of key regulations, have made it difficult to plan and increased fears that the playing field is not exactly level. Mongolia was considered attractive not only due to its mineral wealth but also because it was an open and free economy; however, by the end of 2012 the latter was in question and the international investment community acted accordingly.

Technical Issues

In addition to the more general issues facing the economy, specific problems have weighed on the exchange for a number of years. Disclosure and corporate governance have traditionally been weak, the public float for the large companies is usually below 10%, liquidity is low and shares are usually in the hands of a few insiders. The securities law has also made trading and IPOs difficult. It does not recognise the difference between legal owners and beneficial owners, lacks the legal underpinning for custodian banking, requires that all companies trading in Mongolia be Mongolian firms and does not recognise depository receipts.

The result has been a market of limited transparency and one that provides limited options for raising funds. Major companies were unable to do dual listings while foreign companies with major Mongolian operations, of which there are many, were not able to easily list back in their home markets. Most importantly, because of the lack of custodian banking, major international funds were unable to participate in the market. The absence of these large and long-term investors has had a significant impact on liquidity and contributed to the inconsistent and choppy nature of trade in the country.

Over the past few years, efforts have been made to improve the market. For example, the MillenniumIT system was introduced by the London Stock Exchange Group, which entered a strategic partnership with the MSE. Work began on the system, which was originally developed in Sri Lanka and is now used by 30 exchanges around the world, in April 2011. It went live in December 2012. MillenniumIT provides integrated trading, clearing, settlement, depositary and surveillance services to the exchange.

It is an advanced and scalable platform, and the Singapore Exchange Limited recently selected the system for post-trade processing.

But in parallel with the transition to the new system, the exchange went from T+0 to T+3 to better align itself with international practice. As a result, the Mongolian Securities Clearing House and Central Depository (MSCH&CD) required all its customers to appoint a cash-clearing bank and move their funds currently on deposit in the MSCH&CD’s account at the Bank of Mongolia to the new account. While the requirement was sensible and was part of a shift to reduce risk in the market, it was partly responsible for bringing trading to a virtual standstill, according to brokers. For foreign investors, who conducted most of the trading on the market, the process of opening a clearing account in many cases proved too inconvenient and many chose to stop participating (money on deposit at the central bank can be wired to customers overseas if they so choose).

Securities Law

In 2013 a number of major reforms were introduced that promise to help turn the market around. The Law of Mongolia on Foreign Investment, which essentially reverses the restriction on foreign investment in certain sectors under SEFIL, was passed in October 2013. It is seen as lifting the pall over foreign investment in the country and leading to a general improvement in economic conditions in 2014. More directly related to the stock market, the passing of the new Securities Market Law supersedes the older securities law, which was written in 1994 and amended in 2002. The new law fixes much of what was wrong with the earlier version. It recognises the difference between legal and beneficial ownership, allowing for the use of nominees, introduces a wide range of securities, including derivatives, and allows for over-the-counter trading. Disclosure for IPOs has been improved and companies are now required to publish detailed financials and information about related parties. Self-regulatory organisations for the stock exchange, the depository, clearing institutions and professional groups are also discussed in the new law.

Making Progress

The new law offers a number of improvements that make Mongolian companies more attractive to foreign investors and make Mongolia more attractive to foreign firms. It allows for dual listings and for the use of global depository receipts, which will make large multi-market IPOs possible. It creates a class of securities called Mongolian depository receipts, which permit companies that trade in foreign markets to list shares in the country without subjecting the entire entity to Mongolian regulation and supervision.

This is important as some of the country’s best assets were listed in foreign markets because the Mongolian market is not liquid enough and regulation uncertain. Approximately 30 companies with primarily Mongolian operations trade in international markets, such as Haranga Resources (Australian Stock Exchange), Mongolian Growth Group ( Toronto Stock Exchange) and Mongolia Mining Corporation (Hong Kong Stock Exchange). Listing in foreign markets tends to be quick and easy, and trading can be active in resource-related shares in Australia and Toronto. However, many of the companies trading outside Mongolia have long wanted a home country listing, for credibility and other reasons. Local depository receipts will allow them to gain a Mongolian listing easily. This should in turn help local liquidity, as some of these companies have good assets, are well managed and have transparent financials.

Closing The Gap

What interests international investors the most is the addition of custodian banking to the system. Under the previous law, this role was not recognised. The lack of a banking intermediary to hold shares added an element of risk to investing and made more complicated international products, such as depository receipts, impossible. The new law adds this important step to the value chain and is essential for some investors.

Larger institutions and funds are often prohibited from investing in markets that lack custodians. The hope is that in 2014 these stable investors will start buying Mongolian stocks, which should bring balance, liquidity and possibly more research to the MSE. In a related development, the new law discusses the creation of investment funds. This should also help the market. Local institutions could be created as a result, boosting liquidity and improving the literacy of retail investors. “Without custody there could be no depository receipts, no dual listings,” Andrew Economides, the head of market development at MSE, told OBG.

The new law and related rules should allow for the IPO of ETT (see analysis). The offering, estimated at $3bn, has been repeatedly delayed, the last time in early 2013. The reasons have been many, including commercial, but the lack of the right sort of market regulation and law has also made getting the IPO out the door difficult. The idea is to list the company in three markets – Mongolia, Hong Kong and London – but the previous securities law would not have supported such a complex transaction. The new law should help, as custody and depository receipts, especially, are important to the listing of ETT. The IPO is now slated for 2015 and other possible listings include a raft of privatisations. A. Khangai, the CEO of the MSE, made public comments in early 2013 that these listings and other developments could help the market expand rapidly. He anticipated at the time that total market capitalisation could hit $45bn within three to five years.

Agreements

A number of securities-related agreements have been signed and these should help the local market better integrate with global capital markets. In October 2013 the MSE announced that it agreed to cooperate with FTSE to develop an index and said it was in the running to be classified as a frontier market by FTSE. To be included in this list, a country must demonstrate that its market is well-regulated, open and fair; that it has good market infrastructure; and is large enough to be considered material to global investors. It is a stamp of approval, as well as a driver of investment.

Once a market becomes a part of the FTSE universe, international investors seeking balanced exposure are compelled to buy. Current frontier markets include Vietnam, Sri Lanka and Cyprus. Other agreements include a memorandum of understanding signed between Mongolia’s Financial Regulatory Commission (FRC) and Hong Kong’s Securities and Futures Commission for information sharing and cooperation. The agreement is wide-ranging, covering investor rights, market monitoring and relevant legal development, among other things.

New Steps

The new securities law became effective on January 1, 2014, but signs of market improvement were evident before that date. Equities have been rallying since May 2013, with the Top 20 index up as much as 16.5% since then. Nick Cousyn, the chief operating officer of BDS ec JSC, the country’s largest brokerage, argues that if mining is stripped out, the performance looks even better.

In fact, a number of key shares have been strong despite the troubles faced by the country over the past few years. APU, the beverage maker, is up 10-fold from its 2009 price and did not collapse in 2012 – though it has not increased much. BDS ec is up fourfold from 2009 and rose 20% in 2013. Ulaanbaatar Hotel is up almost eight-fold since 2009. And Suu, a dairy company founded in 1958, is up 60 times over the past four years – though it has not moved much since 2011. “The performance at the stock exchange is better than what the MSE index would have you believe,” Cousyn told OBG.

Positive Signs

Indeed, a degree of optimism has started to grip certain investors. The thinking is that prices have been so knocked down as a result of generally negative news about the market and the economy that companies can now be purchased on the exchange at or near book value. Some foreign investors are beginning to argue that the difficult times have actually been good for the market.

The low-grade crisis into which the country has stumbled has resulted in real action. They point to the new foreign investment law and the passing of the securities law, which was long delayed, as signs that the country is doing what needs to be done to turn the tide. Mongolia is at the brink, they argue, and that is a good thing. “Now is a good time to invest,” said Richard Kobayashi, CEO of Standard Investment. “Everyone is scared.”

New Turns

The optimists say 2014 will be the year of Mongolia’s recovery. The mining projects will get back on track, the securities law will be implemented, foreign investors will return and local investors will start trading more, directly or possibly via funds. Already, a good deal of enthusiasm has been expressed, both locally and internationally, about the new custodian provisions. Foreign banks, such as BNP Paribas, have said they are keen to develop relationships with Mongolian agent banks, while Mongolian banks say they are interested in taking on that role. Developing the right capabilities is not easy. Custodian banking takes an investment in technology, the establishment of relevant procedures, programmes and workflows, and an understanding of a process that still does not exist in the country. Local banks are nevertheless willing to make the commitment, as custody is a fee-based business that nicely hedges interest income.

Some observers have noted a positive response from local companies. In the run-up to the new law, more issuers are choosing to issue financials. They are seeing the benefits of transparency and see that being more open with the market actually encourages investors to invest. BDS ec notes that in 2011 a total of 94 listed companies issued full-year financials. In 2012 that number jumped to 182, and in 2013 31 companies issued half-year reports. No half-year reports were issued in 2012 or 2011.

Concerns & Cautions

Despite the positive news and the good reactions to it, concerns remain. The market is not at all balanced and investment-relevant services have been inconsistent at best. One brokerage, BDS ec, does almost all the trading, despite the fact that the MSE has 79 registered brokers. Risk management is not well-developed and understanding of stocks among the general public is low; while Mongolians have received shares as part of privatisations, some simply do not know what they mean. The MSE grew out of a series of mass privatisations in the 1990s and later distributions. There is no tradition of raising funds, ownership or shareholder participation. The market also suffers from bureaucratic inefficiency and infighting, and has been unproductive. Since 2005, the MSE has had only 10 IPOs – and only one since 2008. Meanwhile, many companies have fallen by the wayside. More than 130 companies have been delisted, while 63 firms have stopped trading. “It is a small exchange, not a lot of companies and not that liquid,” said Kobayashi.

The big question is one of timing. The fact is, not everything changed magically on January 1, 2014. The law is good and shares might be cheap, but the law has to be effectively implemented. This will require the writing of follow-up rules and guidelines that will then have to be correctly used. Questions remain as to whether this can be done properly and efficiently. History suggests that all may not go according to plan. The move to T+3 was sensible, for example, but it led to unintended consequences that left the market effectively shut down. Hogan Lovells, the law firm, said parliament has already amended other laws, such as those related to income taxes, so that they work with the new securities law and that it will have to make several amendments to the Company Law and to the Criminal Code. Conflicts and unexpected surprises are certainly possible, and the law firm wonders whether in the process of putting the new law into practice everything will go smoothly. “Both the FRC and the MSE have been assigned the task of promoting and effectively implementing the new legislation, and this may prove a challenging exercise,” Hogan Lovells said in July 2013.

According to Economides, the implementation regulations should be in place soon and custodian services available by mid- to late 2014. Local and international banks are quite positive on custody. Seminars have been held and relationships are being built, and some of the country’s best banks appear to be up to the task. It might, however, take some time. International banks will have to commit themselves to the project, which will depend to a great degree on the prospects for the market – and to a certain degree on the state of the banks. Financial institutions will have to make a considerable investment in capabilities and will have to be stable enough to inspire the confidence of their counterparties.

Outlook

Market participants are doubtful that the $45bn target will be hit. Too much has to go perfectly for that to happen. However, observers do see a multibillion-dollar market developing in the mid to near term. Prices should rise, and that alone should bring the market back above $1bn soon. What is needed most is for new issues to come to market, and that will depend on the ability of the regulators to put new laws into practice. Optimists say given the current state of the market and the need for foreign investment, conditions are right for that to happen. The consequences of more delays are too great.