Trading places: Working to upgrade and expand the continent’s largest exchange

Rated as the best-regulated exchange in the world by the World Economic Forum’s “Global Competitiveness Report 2010-11”, the Johannesburg Stock Exchange (JSE) occupies a prominent position in South Africa’s economic landscape. Holding its place as Africa’s largest bourse, the JSE continues to invest in upgrading its technological platform, which helps in bringing in domestic and foreign investors alike.

A South African National Treasury decision in 2011 to regard inward listings by foreign companies as local assets should also help in attracting more international firms to list on the bourse, as well as make these equities more accessible to local investors. Areas of growth in 2011 included currency derivatives, which saw a strong increase in trading. Corporate bonds also saw renewed activity that year, in contrast to a global debt market that remained sluggish.

BEGINNINGS: The JSE’s journey to international recognition has been a long one. Borne of a need for primary capital to fund the gold mining operations of the Witwatersrand ridge, the JSE’s foundation in 1887 formalised the haphazard trading that took place in a miner’s tent and, later, a stables on a corner of what is now Johannesburg’s Commissioner Street. The early years of its growth reflected the global interest in exploiting South Africa’s natural resources: nearly half of the capital invested in the exchange between 1887 and 1934 came from foreign investments.

In 1947 the Stock Exchanges Control Act significantly enhanced the JSE’s regulatory framework, setting new capital requirements and establishing governance guidelines that propelled it towards acceptance into the World Federation of Exchanges (WFE) in 1963. The 1990s saw the introduction of limited liability corporate and foreign membership, the closure of the open outcry trading floor and its replacement by the automated Johannesburg Equities Trading System (JETS), the introduction of the real-time Securities Exchange News Service and, at the close of the decade, the beginnings of a sustained effort to tackle insider trading.

DECADE OF GROWTH: At the turn of the millennium, the JSE listed its first exchange-traded fund (ETF) and acquired the South African Futures Exchange. In 2002 it successfully migrated all listed securities to the Share Transactions Totally Electronic settlement system, a T+5 platform that to this day has maintained a zero failed trade record, thereby playing a major role in winning the confidence of both local and international investors. In the same year, the JETS was replaced by the London Stock Exchange’s electronic trading service system.

The rate of development increased further in the following years, seeing the launch of a free float indexing system in conjunction with FTSE, the launch of more ETFs, the creation of AltX (a parallel market aimed at small and medium-sized companies) and Yield X ( currency and interest rate products). In 2005 the JSE demutualised and incorporated as JSE Limited in South Africa, the public company that operates the exchange today. In 2006 the JSE listed on its own main board.

In 2009 the JSE acquired the Bond Exchange of South Africa (BESA), now known as the Interest Rate Market, which provides a venue for the trading interest rate products, namely bonds and interest rate derivatives. Today the JSE connects buyers and sellers in five different financial markets, namely equities, equity derivatives, commodity derivatives, currency derivatives and interest rate products.

MARKET STRUCTURE: Having undergone a 125-year transformation from a single-equity trading floor to a horizontally and vertically integrated, well-regulated, full-service securities exchange, today’s JSE is recognised as one of the world’s leading exchanges. With 403 listings and a market capitalisation of R7.27trn ($889.3bn) as of December 2011, it is ranked 20th largest stock exchange in the world by the WFE.

The JSE’s main board, listing 337 companies, represents the central trading forum from which a number of other boards and markets have been developed as the exchange has expanded. These include the AltX, with 64 listed companies in January 2012, allowing investors to direct capital to smaller companies not yet able to list on the JSE main board, and offers the same trading, settlement and surveillance services as the larger market; and the commodity, equity and currency derivative markets, which allow for short-selling and provide a platform for price discovery and efficient risk management through futures and options.

The expansion of the South African Bond Market through enhancements such as the development of the spot bond market and interest rate derivatives remains a strategic priority for the JSE. While Africa accounts for only 2% of the global bond market, South African bonds constitute 96% of that figure. The bulk of it comprises government debt, with corporate debt maintaining a level of around 20% in recent years.

INDEXING: The JSE is indexed by the FTSE/JSE Africa Index Series, a partnership JSE and the FTSE Group. The global classification structure consists of three levels: the FTSE JSE economic groups, made up of 11 economic sectors from basic industries and consumer goods to utilities and financials; the FTSE JSE industrial sectors index, which runs to 44 categories, such as mining, oil and gas, chemicals, construction, household goods, beverages, leisure and hotels, transport, banks, insurance, real estate and information and technology; and finally the FTSE JSE industrial sub-sectors, 112 categories spanning activities such as oil and gas exploration, gold mining, platinum mining, automobiles, consumer electronics and household appliances.

The FTSE JSE partnership has resulted in a number of indices which can be grouped into six categories: the Africa Headline indices, Africa Tradeable indices, Africa Sector indices, Africa Secondary Market indices and the Africa Specialist industries. The JSE All Share index represents the benchmark index, while the press and the investment community frequently use the FTSE JSE Top 40 index as the primary performance tracker. In 2010 it introduced the FTSE JSE Sharia All Share index, designed to reflect the performance of the sharia-compliant companies. In 2004 the exchange launched the JSE Socially Responsible Investment index in answer to the growing debate around sustainability, which is the first of its kind in an emerging market.

MARKET PERFORMANCE: The JSE, like exchanges around the world, has faced a challenging environment in the wake of the global credit crisis. Year-end values for 2011 showed little movement on their 2010 counterparts, despite the index volatility that characterised the intervening period. However, in an era of market uncertainty and global sovereign debt concerns, this steady performance compares well with exchanges worldwide: The FTSE JSE Top 40 index showed a marginally negative return of -0.59% as of December 30, 2011, compared to the -18.3% of the Euro Stoxx 50, - 15.6% of Germany’s DAX, the -19.8% of Hong Kong’s Hang Seng or the -5.6% of London’s FTSE 100. Moreover, market capitalisation rose by 10.4% over the year from R6.58trn ($805.8bn) in January 2011 to R7.27trn ($889.3bn) in January 2012, according to the JSE’s data.

In sector terms, food producers made a particularly strong showing with 13% growth, followed by the oil and gas segment (11%), and industrials (6%). On the negative side, construction sector stocks lost 26% of their value over the year. The mining sector also recorded a significant dip, declining by 11% over the year despite a rise of 22% in the coal segment, largely due to the poor showing of platinum stocks (-28%).

The AltX was the strongest performer of the JSE’s boards in 2011, returning 21.6% to beat the All Share, small cap and fledging indices. Market capitalisation grew by around 60% over the year, which saw three new listings and four companies (Morvest, Taste Holdings, Santova and Rolfes) step up to the Main Board.

Finally, like other WFE members, a relatively weak performance in 2011 meant companies were hesitant to list on the JSE, although an initial public offering (IPO) pipeline exists. Over 2011, 16 companies with a combined market capitalisation of more than R35bn ($4.3bn) listed on the exchange, while 15 companies delisted.

BONDS: On the debt side, despite a challenging environment caused by inflationary pressures and exchange rate volatility, activity on the nation’s primary bond market remained healthy. According to the JSE, the nominal value of total listed bonds increased in 2011’s third quarter by 3.4% over the previous three months, following similar performance in the second quarter. Corporate bonds, dominated by financial sector issuances, also showed renewed activity, maintaining a trend that has seen the South African corporate bond market buck a global trend of decline (see analysis).

AREA OF GROWTH: Trading of currency derivatives on the JSE saw strong growth in 2011, boosted by global economic volatility, low spreads and increased product offering. Both value and volume traded more than doubled year-to-end-November 2011 over the same period in 2010, extending a trend of growth which has been sustained since 2007 as investors have moved derivative trades away from over-the-counter trading and onto the JSE’s platform.

“I’m delighted with this growth, which demonstrates that the JSE is listening to clients and providing a service that is needed in the market. The growth also indicates that investors are moving trades onto the regulated market as they are asked to improve their risk profile. On-market instruments require no foreign exchange clearance and are settled in rands,” Warren Geers, the general manager of derivatives trading and head of the currency derivatives market, told the local press in late 2011 regarding the JSE’s ongoing growth.

The strong performance of the JSE’s currency derivatives can in part be ascribed to its efforts in 2011 to make this market more attractive by providing incentives for larger currency deals and enhancing trading flexibility for investors. The new fee structure reduces costs by 33% for deals including more than 7500 contracts and a 50% reduction for deals greater than 10,000 contracts, with a fee cap of R35,000 ($4284).

In a bid to encourage same-day trading, the JSE has removed the fee for the second leg of all intra-day currency trades, while it has promoted cross-currency trading by only placing a charge on one side of the transaction. Increased trading options for investors came in the form of any-day expiry currency products, which allow investors to pick the expiry date of the contract, and the maxi currency contract aimed at offshore market participants and local institutional investors, which has introduced a contract size of $100,000.

NEW LISTINGS: In late 2011, the treasury made a change to its inward listing rules, allowing foreign-domiciled companies to be treated as domestic listings (see analysis). The move makes the JSE a more attractive destination for foreign firms looking to tap into local liquidity. As of February 2012, 38 securities with primary listings on exchanges as far afield as London and Toronto hold secondary listings on the JSE, and increasing this number remains a priority.

History and geography are joined in making Africa the principal target of the JSE’s efforts to attract dual listings and IPOs from beyond its borders. At present 12 African companies, four African debt instruments and an Africa ETN are listed on the JSE. In its bid to add more African firms to the JSE, the bourse is competing with other international exchanges, such as London’s Alternative Investment Market (AIM).

Its stance in this regard is a proactive one, according to Nicky Newton-King, the JSE’s CEO. “We know who we want. It’s a question of our saying to them: ‘Hold on, if you are considering us versus AIM or the Professional Securities Market in London, why would you do that? What’s working for you there? What can we do for you here? How can we pair you with investors?’ We are not just waiting for them to come,” she told OBG.

Thanks in part to a regulatory regime that encourages inward capital flows, the JSE also continues to attract foreign investors. Foreign participants on the JSE are not subject to a foreign registration process and are exempt from exchange controls, withholding taxes and ownership limits.

NEW TECHOLOGY: While the JSE looks to build on its connections with external markets and investors, it is also enhancing its technological platform. The bourse’s current equities trading platform is licensed from the London Stock Exchange, which operates it remotely through a link that was, at the time of its installation, considered low latency.

However, with latency speeds now measured in microseconds, the increasing popularity of high-frequency trading and a number of connectivity-related incidents in 2009 and 2010 that forced trading on the equities market to halt, the JSE is moving its trading engine from London to Johannesburg. In February 2011 the JSE announced the signing of a licensing agreement with MillenniumIT, a wholly-owned subsidiary of the London Stock Exchange Group, to move its equity market trading onto Millennium Exchange planned for 2012.

This significant technological shift takes place in parallel to another: the JSE will move from the current T+5 settlement system to what has become the global benchmark, T+3. Phase one of the transition, a consultation process with market participants, was completed in 2007, but the need for the JSE’s clients to update their back office technology has pushed implementation of the transition to after 2012.

In the meantime, the JSE continues to address other areas of its technological framework. “Platform upgrades are a constant process,” Newton-King told OBG. “We are tech-dependent, with five different markets. All that technology will have to be replaced over time as new products are introduced. You have the big back office system, the equities trading engine, changes for T+3, co-location, new derivatives, engines which are going to need to go in due course, clearing, and so on. On the technology front we are busy in perpetuity.”

REGULATION: In boosting market activity, the JSE is significantly aided by its reputation as a well-regulated exchange. While the Financial Services Board (FSB) retains regulatory authority, its relationship with the JSE differs to that seen in most other jurisdictions.

“The regulatory environment in this country, where the JSE takes a large role with frontline regulation, is different to quite a number of other exchanges that have preferred not to be in the regulatory business, but we think regulation is critical to our brand,” Newton-King told OBG when discussing the bourse’s regulation.

The JSE sets listing requirements, regulates listed companies, establishes trading rules and monitors compliance with them, and takes disciplinary action under its own rules. The FSB supervises the JSE in the commission of its regulatory duties and, as the JSE has no criminal or civil jurisdiction, processes any cases where statutory legislation has been contravened. The JSE’s drive to enhance its own regulatory environment has been central to its 15-year transformation from a local exchange known for insider trading and opaque processes to the modern, transparent bourse that it is today.

External regulation is carried out according to the Securities Services Act (No 36 of 2004), which is shortly to be replaced by a Financial Markets Bill. The new bill is intended to strengthen the regulatory framework, establish more effective supervision, improve crisis resolution, and enhance accountability through international assessments and peer reviews for the entire financial sector. Having been put out for consultation, it is expected to be put in place in 2012.

The JSE has also implemented the King Code of Governance Principles, the current iteration of which is commonly referred to as King III. The code is a response to changes in international governance trends and, although it is implemented on a voluntary “comply or explain” basis, aspects of it have been made mandatory by the JSE by their inclusion in the listing rules.

These regulatory changes are set to take place against a fundamental reshaping of the financial sector into what has become known as the “Twin Peaks” model, by which the South African Reserve Bank (the country’s central bank) is to adopt responsibility for prudential regulation and oversight of financial services, while the FSB takes on the roles of market conduct supervision and consumer protection.

Although questions remain regarding the detail of the final implementation these changes in regulation, the financial services sector has broadly welcomed the initiative for its potential to reduce the cost and complexity of compliance, as well as systemic risk.

FUTURE CHANGES: The treasury is reviewing the taxation of financial derivatives, causing concern for some financial institutions. A proposal to tax derivatives on a mark-to-market basis gives rise to a problematic scenario in which taxpayers will be compelled to pay tax on unrealised gains, while the possible removal of an exemption from secondary tax for brokers may make current hedging practices prohibitively expensive.

Another cause for concern for some market participants is the replacement of the Securities Services Act with the new Financial Markets Bill and the possibility of new execution requirements for the bond market. In its current form, the act only requires off-market trades in listed securities to be reported to the registrar of securities, and alteration to this provision could change the manner in which the bond market operates. Striking the right balance between regulatory oversight and the interests of market participants will therefore be a central concern of the treasury in 2012.

OUTLOOK: South Africa’s bourse exhibited a strong start to 2012, and at a structural level has shown its commitment to expanding the depth and scope of market activity. Nevertheless, weak global markets and longstanding structural issues in the economy, such as high unemployment, remain significant challenges to future growth. Despite these potential challenges, a growing corporate bond market and regulations that simplify market listings project a positive economic future.