Futures Gazing

With many exchanges across the Gulf facing liquidity issues in underlying stocks, should they even be considering derivatives?

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By  Mark Johnson Published  April 4, 2005

|~||~||~|Some would argue the Arab financial world has enough to deal with in simply growing deep, liquid, primary and secondary markets, without having to worry about the complicated issues of establishing active derivatives markets, too. As one market leading expert put it: “If you can’t even do enough daily trading in the apples and bananas on your market stall, how are you going to create enough interest in the more exotic fruits?” The old familiar village market analogy always helps to get the message across, but these are modern times, and – let’s face it – when was the last time you went to a village market? Most of us probably head straight for the big, shiny supermarket, where the choice is amazing and everything is on offer. The various markets across the Gulf are acutely aware that they exist in the age of the modern market and, while no one’s expecting derivatives trading in the region to spring up overnight, those who believe in the concept of early mover advantage are already pressing ahead. After all, there is a lot at stake, with a growing number of countries around the region all vying to become major financial hubs of one sort or another: In the United Arab Emirates (UAE), Dubai is already emerging as a clear leader, with its tough, world-class regulatory framework and its big shiny new international financial centre — the DIFC; Manama in Bahrain is beginning to shape up as an Islamic finance centre; Qatar recently announced plans to join the throng with its planned Qatar Financial Centre in Doha; and Oman is carrying out studies to develop the Muscat Securities Market (MSM) into a larger, more international financial facility, and is already establishing electronic links with other regional exchanges, such as the Abu Dhabi Securities Market (ADSM) in the UAE. Moreover, these regional markets are right to be preparing themselves now, because, already, some of the world’s leading exchanges and finance houses are eyeing the potential gains to be had from getting in on the ground floor as far as developing the region’s derivatives industry is concerned. For example, New York Mercantile Exchange (Nymex) is currently looking at setting up an open-outcry commodity exchange in Dubai in the UAE, where it plans to trade energy contracts, including energy futures and options. In October last year it was announced that an all-electronic exchange, the Dubai Gold and Commodity Exchange (DGCX), will open for trading in the second half of 2005 with plans to trade a range of metals, commodities and - in a move that could steal a march on Nymex’s plans - energy futures contracts. Significantly, this exchange is one of the first Arab/Indian joint ventures to emerge in the region’s financial markets, and is a clear indication of the growing close relationship between the Indian sub-continent and the Gulf Arab nations. The DGCX was formed by the Dubai Metals and Commodities Centre (DMCC); the Multi Commodity Exchange of India Ltd (MCX); and Financial Technologies (India) Limited (FTIL), a commodities software company, in a three-way joint venture. Additionally, the DGCX says it will offer futures and options trading in all its listed commodities. Colin Griffith, who is executive director for the gold and precious metals sector of the DMCC, says: “As the exchange develops we expect a significant amount of trade in silver, steel, freight, cotton and energy contracts, so that we can achieve a balanced portfolio with futures and options contracts available for all listed commodities.” In neighbouring Oman, the Muscat Securities Market (MSM) says it’s currently involved in a study, which is looking at the feasibility of introducing derivatives based on equities within its market. “It will depend on the recommendation that our study comes up with,” says MSM deputy director general, Sulaiman Mohd Al-Rashdi. “We are trying to investigate what the real needs of the investors are.” He says the MSM doesn’t simply want to imitate other markets by offering more of the same, but at the same time it needs to attract more liquidity to its markets: “We are keen to do something that will add value to investors by creating products and opportunities that will be attractive to them and improve liquidity. Derivatives are not readily available throughout the Gulf at the moment, so we are keen to develop them within the Omani markets.” Of course the age-old issue of liquidity is never far from peoples’ minds. The Dubai International Financial Exchange (DIFX), which is due to go live in the third quarter of 2005, will trade US dollar denominated stock, bond, fund, Islamic and, eventually, derivative instruments. The DIFX expects to list instruments from countries across the Gulf region and further afield, including India and South Africa. These are likely to include depositary receipts (DRs), which the exchange hopes will help to keep liquidity high on the exchange. More importantly, DIFX chairman, Lynton Jones, says the development of a derivatives market on the exchange will in fact be key to establishing strong liquid primary and secondary markets on the DIFX: “Derivatives are vital to the liquidity of underlying markets because they allow those who agree to act as market-makers in the underlying stocks to provide the services of always being a buyer or a seller.” In other words, these liquidity providers can only offer this service if, over time, they have access to and the use of derivatives on the underlying instruments against which to offset their market-making risk.” Oman’s MSM has sets its sights on becoming a leading regional exchange, and although derivatives are just one of a number of new products they are looking at, Al Rashdi says he knows that introducing a derivatives element will necessitate some resistance in the early days: “We recognise that people have traded stocks for a long time and that they are comfortable with this. When you introduce something else, like derivatives, you don’t really own anything and it is a tricky thing, but it is simply an education process.” He adds that a little resistance is always a price worth paying for innovation: “Every investor who is driving the market would like to diversify, and we feel there is a need for diversification now, not least because we are suffering on the liquidity front. There is more and more ownership of existing stocks so we need to introduce new blood to the market that will give investors the opportunity to diversify and make the liquidity deeper.” However, introducing new blood to a market shouldn’t necessarily lead to that blood being spilled on the trading floor. There are big risks in trading derivatives where the underlying market is illiquid, says Gregor Pozniak, deputy secretary general at the Federation of European Securities Exchanges (FESE): “If you have no liquidity you have either no trading or low quality trading, because it is only speculative. We hear a lot about entry opportunities but you must also have exit opportunities, there must be liquidity as well. For the derivatives markets to be liquid, liquidity in the underlying is even more important, because if you create derivative products on non-liquid underlying products you are getting closer to the invitation to abuse. If you pretend there is a liquid market in something that is not liquid the step towards promoting abuse by a few fast players is narrow.” A regular speaker on exchange issues, Pozniak has an in-depth knowledge of the structure of the financial services industry. He adds that quality markets distinguish between classes of liquidity and they develop special trading models for less liquid stocks. But he cautions on exchanges setting out their derivatives stalls too soon: “Bringing in liquidity providers (market makers) who will do something for less liquid stocks is vital, but only once the stock is established would it then be time to create a derivative on that stock.” However, there is a way around the obstacle of illiquid cash markets, where derivatives are concerned. Many exchanges across the region could benefit from creating index futures, where a number of stocks are combined. Pozniak believes this would be a better place for exchanges in the Gulf to start: “Speculating on an index is speculating on something like the combined liquidity on the underlying, and it could even give traders a more complete picture of the market. We saw this in central and eastern Europe, where most of these countries took their first steps into the derivatives world via index futures.” Because investors in the Gulf region have been used to buying and holding stocks and bonds for a long time — thus draining the market’s liquidity — even index futures may not suffice, says Pozniak: “Definitely, I would advise against going for single stock derivatives too soon. I would rather see them go for an index, or even a broader index, perhaps a regional index, that would certainly help to create or to increase interest in the underlying.” Of course these markets are all operating within an Islamic environment, which introduces the potential need for sharia-compliant derivatives, which places even more strain on liquidity issues. “Islamic financial products, in general, are in such high demand that they are not traded,” says DIFX ceo, Steffen Schubert. “By which I mean that Islamic products are so popular that they are sucked up by the buyers, tucked away into portfolios and left there until maturity, so there would need to be multiple investment opportunities to help develop an active secondary market. Moreover, it is often argued that derivatives by definition are un-Islamic, because they technically viewed as gambling – one of the primary taboos of sharia principle. However, this hasn’t dampened the region’s interest in and willingness to adapt to derivatives and many accept that if the underlying instrument is acceptable under sharia law, then a derivative counterpart would be allowed on the basis of the underlying suitability. Also, Pozniak believes the level of acceptance of derivatives will vary from market to market. “The Tunis and Beirut exchanges may have more flexibility in what they offer on the Islamic products front, because they are less stringent on their requirements.” Schubert says the current debate over sharia compliance could slow development of the region’s markets: “The Gulf countries do have a lot of legal impediments to accessing these markets. But there is a demand for derivatives, and we will trade them, because we are very much a market dependent organisation, it’s not us pushing for them. Practitioners are already asking us about the ability to trade derivatives on these markets.” Oman could emerge as a winner in the derivatives arena because it is the only state that does not apply sharia or Islamic thinking to its financial markets. MSM’s Al-Rashdi confirms this: “For the moment, sharia is not on the Omani agenda. We started out focusing on stocks, then came bonds and in 1995 mutual funds. Our next target is to develop derivatives.” Of course, it’s not only exchanges that are targeting the derivatives opportunity. The International Swaps and Derivatives Association (ISDA), a global industry body representing the over-the-counter, or off-exchange, trade in derivatives, has been investigating the region’s potential since May 2003. ISDA’s Middle Eastern Working Group was set up to look at the legal and regulatory issues affecting the derivatives industry in Islamic jurisdictions. The working group says it’s focused on the UAE, Bahrain, Saudi Arabia and Qatar and is developing Islamic law-compatible ISDA documentation. Almost two years on, ISDA’s Middle East Working Group still hasn’t made any public announcements regarding its findings, and there is little mention of the organisation among the banking community in the region. This is hardly surprising given the region’s approach to derivatives thus far. There are those who believe that regional investors and institutions will find it more comfortable to trade on-exchange derivatives, than doing it outside of that safe regulatory system. The only question is, which markets will win the lion’s share of the business, when it finally comes?||**||

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