Opening up Saudi Arabia. To Foreign Institutional Investors

Transcription

1 Opening up Saudi Arabia To Foreign Institutional Investors

2 2 Opening up Saudi Arabia to Foreign Institutional Investors rowtø Market liberalization in Saudi Arabia has been hotly anticipated for a long time. This paper explains what it means for fund managers and institutional investors. This communication is provided by Advent Software, Inc. ( Advent ) for informational purposes only and should not be construed as or relied on in lieu of, and does not constitute, legal advice on any matter whatsoever discussed herein. Advent shall have no liability in connection with this communication or any reliance thereon.

3 3 Emerging Market The announcement that the Saudi Arabian Stock Exchange the Tadawul would open up to Qualified Foreign Investors (QFI) on June 16, 2015 had long been expected. The Capital Market Authority (CMA), the Saudi Arabian regulator, published its Draft Rules for Qualified Foreign Financial Institutions Investment in Listed Shares in August This market liberalization in Saudi Arabia is catching the attention of fund managers and institutional investors. The Saudi Arabian economy accounts for approximately 50 per-cent of the $1.6 trillion Gulf economy, according to the Tadawul, and it is the 19th largest global economy. Its exchange has a market capitalization of $590 billion making it the biggest in the Middle East, and putting it ahead of Russia, Indonesia and Malaysia. Deutsche Bank analysis highlights that Saudi Arabia is the most liquid Middle Eastern economy with a six months average daily trading volume of $2.5 billion, accounting for 65 per-cent of regional liquidity. Despite this, foreign holdings account for a mere 1.6 per-cent, or just $9 billion of the total market capitalization in Saudi Arabia. Detractors of the Saudi Arabian market argue it is heavily reliant on oil, a highly volatile commodity as recent events can testify. Nonetheless, this fails to account for the fact that there are more than 160 listed securities on the Saudi Arabian stock exchange covering approximately 15 diverse sectors. The Saudi Arabian market is very liquid and it has large foreign reserves. There are a number of listed companies and we expect there to be another 100 listed companies over the next four to five years with Initial Public Offerings (IPOs) of varying sizes, says Tim Plews, partner at Clifford Chance in Riyadh. One head of asset management in Riyadh agrees. We are going to see a number of IPOs over the next few years and growth in the market and stock opportunities for investors. I believe there will be greater interest in the Saudi Arabian market, particularly when the regulators get more comfortable. When this occurs, there will be much more foreign investment into Saudi Arabia, he says. There is already speculation that MSCI could upgrade Saudi Arabia to its Emerging Market Index from its Frontier Market Index as early as 2017, something which could facilitate an additional $40 billion of capital inflows into the Kingdom. The opening up of Saudi Arabia will result in the country becoming part of the emerging market indexes. At present, only active fund managers are transacting in the Saudi Arabian equity markets but such an

4 4 Opening up Saudi Arabia to Foreign Institutional Investors

5 5 The Saudi Arabian economy accounts for approximately 50 per-cent of the $1.6 trillion Gulf economy, according to the Tadawul, and it is the 19th largest global economy. upgrade will lead to a surge in exchange traded funds (ETFs) and other passive managers entering the market, says Khodor Tajeddine, head of professional services for the Middle East and North Africa at SS&C Advent. Kaushiq Kodithodika, regional sales director for the Middle East and North Africa at SS&C Advent, concurs. Any upgrade of Saudi Arabia on the MSCI will lead to significant capital entering the country, and this is something I believe will happen in the next few years. Saudi Arabia is an untapped market offering potential for fund managers and their end investors. Fund managers are being encouraged to attain first mover advantage. The decision by Saudi Arabia to open up its capital markets to foreign institutional investors is a momentous occasion. I anticipate a huge number of fund managers, investors and global banks will look to take advantage of the enormous opportunities available in Saudi Arabia. Saudi Arabia, more broadly, has a huge consumer market and excellent market infrastructure, and the changes will be very exciting for the fund management and institutional investor community, says Kodithodika. Tajeddine agrees. The opening up of the Saudi Arabian market to international investors will lead to greater market efficiencies and scalability, and this is going to be very exciting for some asset managers, particularly as Saudi Arabia is the most liquid, largest and diverse market in the MENA region, he says. What do the rules mean for fund managers and investors? The CMA has designated any bank, brokerage, securities firm, asset manager, investment fund or insurance company with Assets under Management (AuM) in excess of $5 billion and operating out of and supervised in a jurisdiction deemed to have regulatory equivalence to that of Saudi Arabia as a QFI. These institutions will therefore be allowed to register under the new scheme. There was uncertainty in the draft regulations as to whether collective investment schemes, pension funds and sovereign wealth funds would qualify as QFIs under the newly liberalized Saudi Arabian regime. It has now been confirmed that these investors will be allowed to operate as QFIs, says Arindam Das, regional head for the Middle East and North Africa at HSBC Securities Services. A list of countries deemed to meet regulatory equivalence has also been compiled by the Saudi Arabian authorities. The CMA has provided a list of countries which have equivalent or acceptable regulatory and monitoring standards to that of Saudi Arabia. It is also critical these countries are sufficiently sizeable so as to help ensure diversity and liquidity, adds Das. Registrants will be evaluated by an Authorized Person (AP) on behalf of the CMA, before attaining authorisation. These institutions must also have a minimum of five years experience in the investment or securities industry to qualify. As such, this will preclude individual investors or small asset managers, many of whom specialize in identifying niche or esoteric markets from participating. The $5 billion number is very high and will shut out a lot of asset managers, particularly frontier or emerging market managers which do not possess those sorts of assets. But I suppose the regulator in Saudi Arabia simply wants to ensure it attracts blue-chip investment companies into the jurisdiction, says Plews of Clifford Chance. However, such requirements are not an uncommon phenomenon with newly liberalized markets. China, following its

6 6 Opening up Saudi Arabia to Foreign Institutional Investors Foreign investors also do not have untrammeled access to the Saudi stock market. No single QFI can own in excess of five per-cent of listed shares from a single issuer, while a 20 per-cent cap is also imposed on aggregate QFI ownership of issued shares in a single company. initial passage of its own Qualified Foreign Institutional Investor (QFII) scheme in 2006 set a minimum AuM threshold of $5 billion and five years- experience for asset managers hoping to invest in a limited set of cross-border securities. However, China subsequently reduced the thresholds to $500 million and two years respectively. As these markets acclimatize to the changes, it is possible barriers to entry will be reduced. As the regulatory regime becomes more comfortable with the changes it has implemented, I believe there will be further reforms down the line, comments Kodithodika of SS&C Advent. Another restriction surrounds multimanager structures. The final regulation confirms that a QFI client cannot appoint or register under multiple QFIs. It must only use one QFI, says Das. While citizens of Saudi Arabia and the Gulf Cooperation Council (GCC) have been permitted to invest directly into domestic stocks, foreign investors historically could only gain access indirectly through total return swaps or exchange traded mutual funds, which could be costly and complex. Non-GCC investors can gain exposure to Saudi Arabian shares through swap agreements with CMA authorized persons. It is fairly straightforward, and the Saudi Arabian authorities recognize the concept of beneficial ownership when it involves a regulated activity by a CMA authorized person. Nonetheless, having a direct holding in Saudi Arabian shares will probably give non-gcc investors more comfort, says Nabil Issa, partner at King & Spalding in Riyadh. These swap positions if held by a QFI, however, must now be converted to a QFI National Investor Number so as to ensure financial institutions have exposure to the Saudi Arabian market through a single channel only. Foreign investors also do not have untrammeled access to the Saudi stock market. No single QFI can own in excess of five per-cent of listed shares from a single issuer, while a 20 per-cent cap is also imposed on aggregate QFI ownership of issued shares in a single company. The regulator has also stated that QFIs cannot account for more than 10 per-cent of the total stock market value, and this will include any QFIs with swap exposures to underlying Saudi Arabian assets. A paper published in January 2015 by BlackRock argued these limits could prove restrictive for foreign investors and act as a disincentive to them entering Saudi Arabia. BlackRock also warned the rules could impede Saudi Arabian companies from being included in industry benchmarks. However, the 10 per-cent figure is far higher than many would have predicted. Furthermore, it is expected these caps will be liberalized eventually. Admittedly, there are restrictions around foreign share ownership but I strongly believe there will be further liberalization of Saudi Arabia s capital markets in due course, comments Kodithodika. By having a direct holding over these underlying assets instead of through a swap, institutional investors and fund managers will probably gain enhanced asset security and ownership rights. Furthermore, it is reported that listed corporates must now disclose annual reports in English in what should bring Saudi Arabia into line with global corporate governance norms.

7 The opening up of Saudi Arabia will result in the country becoming part of the emerging market indexes. 7

8 8 Opening up Saudi Arabia to Foreign Institutional Investors Saudi Arabia is an untapped market offering potential for fund managers and their end investors.

9 9 While citizens of Saudi Arabia and the Gulf Cooperation Council (GCC) have been permitted to invest directly into domestic stocks, foreign investors historically could only gain access indirectly through total return swaps or exchange traded mutual funds, which could be costly and complex. Improvements in Market Infrastructure and Regulation One of the biggest stumbling blocks (in addition to the difficult-to-access market) was that Saudi Arabia did not have an independent custody model, which prevented US mutual funds from transacting in Saudi Arabian securities as the dearth of an independent custody model would put them in breach of the US Securities and Exchange Commission s (SEC) Rule 17(f)5 regulations. Rule 17(f)5 regulations outline the basic standards to which foreign depositories must adhere to. Saudi Arabia had historically required custody of securities to be undertaken by a local brokerage firm, which exposed foreign investors to counterparty risk and would potentially reduce their ability to reclaim assets in the event of the counterparty s insolvency. It also exposed foreign investors to fraud as these local brokers could execute client trades without permission. The CMA has since announced that foreign investors can appoint an independent custodian to hold listed securities instead of having to utilize a local broker. This will give the custodian enhanced controls over client assets, and the settlement of any client transactions. This will help ensure proper controls and segregation between assets held in custody by a custodian bank and local brokers. Making the custody account inaccessible to local brokers will alleviate many of the concerns institutional investors and fund managers had about having assets held at a local broker, such as fraud or unauthorized trading activity, says Das. In addition, investors will be permitted to use multiple brokers through a single custodian bank. A legal briefing published in May 2015 by Clifford Chance said the CMA indicated the Tadawul would hold workshops to educate market participants on what these changes mean in practice. However, there have been reforms in other areas, most notably taxation around dividend payments to foreign investors. Saudi Arabia has historically imposed a withholding levy of five percent on dividends paid out to non-saudi Arabian citizens in foreign jurisdictions. The challenge, however, has been around identifying the financial entity responsible for collecting and accounting for this dividend taxation. There has been uncertainty about who collects and accounts for the tax as applied to foreign investors. This precipitated considerable confusion because there was debate as to whether it was the corporate paying the shareholder dividend, the broker or the custodian bank. However, the Department of Zakat and Income Tax confirmed that the corporate responsible for the dividend payment would be the entity responsible for withholding that levy, says Das. Operational challenges Like many other emerging market economies, Saudi Arabia s trading settlement is conducted in a T+0 settlement time-frame, which requires the Tadawul s market participants to adhere to same-day delivery of securities. This means all trades must be pre-funded. It can also mean investors are waiting several hours to receive delivery of securities (as the transaction is pre-funded), which can expose them to counterparty risk at local broker dealers. It can also exacerbate operational risk and errors as incorrect trades cannot be cancelled or amended prior to settlement. However, it is possible to back-trade if there is an issue. A paper by HSBC Securities Services highlights

10 10 Opening up Saudi Arabia to Foreign Institutional Investors Market liberalization in Saudi Arabia has been hotly anticipated for a long time. Its markets are deep and liquid, and it could prove lucrative for asset managers looking towards frontier or emerging economies. that because the Saudi Arabian Riyal is pegged to the US Dollar, investors do not incur currency risk on pre-funded transactions as they would if the currency was floating. As the Saudi Arabian Riyal is pegged to the US Dollar, currency risk is much lower and this makes the Saudi Arabian market more attractive to international investors, says Tajeddine. Irrespective, a T+0 trade settlement system does pose operational and logistical challenges for investors into the Saudi Arabian market. China, which also adopts a T+0 settlement time for securities, has initiated reforms to enable greater market participation in the Stock Connect trading link it has established between Shanghai and Hong Kong. It was announced that investors through Stock Connect can transfer securities to brokers for settlement once sells have been executed. This small change has prompted a surge in interest in the Stock Connect initiative. There is nothing to prevent Saudi Arabia adopting a comparable approach and generating similar levels of trading activity. This is tempered with caution though among some market participants. A number of foreign institutional investors have raised concerns about the T+0 settlement time-frame and the CMA is fully aware of the challenges posed by this settlement system. Reform of T+0 is something I do not anticipate in the near future, comments Issa. There is also a possibility for foreign institutional investors to undertake a form of synthetic settlement in a T+2 settlement timeframe, thereby eliminating the obligation to pre-fund transactions. There has been guidance and clarification stipulating that a Saudi Arabian-based bank can offer credit facilities to foreign fund managers or investors which can help facilitate a longer settlement cycle. In other words, a trade could be settled in T+0 in Saudi Arabia using the credit facility but settled outside of the market with the investor or global custodian bank through a sub-custodian bank on a T+2 basis or T+3 basis, says Das. Others agree. T+0 is a challenge and there does not seem to be much impetus among regulators to reform T+0 at present, but there are mechanisms by which local brokers can assist clients without having to settle in T+0, says the asset manager. The ability to settle synthetically in a different settlement time will be attractive to end investors. Some investors are nervous about the counterparty risk issues that arise because of T+0 but synthetic settlement is a way by which firms can reduce those risks until the T+0 matter is agreed on. Once that happens, dealing with vanilla equity via Saudi Arabian brokerage firms will become much more appealing and cost effective, says Kodithodika. While there are a number of administrative and operational challenges when investing into Saudi Arabia, there are ways by which managers can overcome these. Having a robust internal infrastructure and technology systems is critical as these can help mitigate risks and operational issues that might arise in these frontier economies. Having robust technology also helps demonstrate that asset managers operations and processes are of institutional standard. Given the dominance of institutional investors be it pension funds, insurance companies or sovereign wealth funds it is crucial managers possess excellent technology systems which meet the high standards laid down by these allocators operational due diligence teams. An inability to showcase high-quality technology is usually a red-flag for many operational due diligence professionals at institutional investors.

11 11 The future looks bright Going forward Market liberalization in Saudi Arabia has been hotly anticipated for a long time. Its markets are deep and liquid, and it could prove lucrative for asset managers looking towards frontier or emerging economies. Reforms have been made to its operational infrastructure, particularly around custody, while its T+0 settlement timeframe is something that managers can work around. The Saudi Arabian regulators have adopted sensible policies and regulations governing foreign investment. The rules are transparent and well-thought out, and this will certainly help facilitate greater inward investment into Saudi Arabia s capital markets. While I am unsure as to whether it will become a regional hub of the GCC, I do believe that these sensible reforms of Saudi Arabia s capital markets will turn the country into a regional financial heavyweight within the next five years. The changes will undoubtedly bring about a number of exciting and potentially profitable opportunities for foreign fund managers, says Kodithodika.

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