While recent developments in Saudi Arabia are likely to have a positive impact on the securities finance market in the Middle East and North Africa, significant regulatory and infrastructural constraints continue to hold the market back in many other parts of the region. Paul Golden reports.

In June, MSCI confirmed that Saudi Arabia would be upgraded from a standalone market to an emerging market on its index. While Saudi Arabia remains relatively untapped by global investors, with foreign ownership of locally listed securities comprising less than 5% of the total, Deutsche Bank predicts this will change as inflows could reach $35bn post- MSCI inclusion on top of the $5bn already projected following FTSE Russell’s market upgrade in March.

Richard North, EMEA head of securities finance at Citi, notes that securities finance is becoming more relevant in MENA as short selling is being authorised by the Emirates, Qatar and Kuwait, which should increase liquidity and flow and increase domestic stock lending activity over the coming years. “In terms of opportunity, Saudi Arabia has the biggest market share in the Middle East and has the potential to be a key market with particular focus on upcoming IPO activity as a fundamental driver,” he continues.

Limited liquidity creates commercial challenges at times where there isn’t a viable equity financing avenue, but North says this doesn’t prevent access to the market, either physically or synthetically via swaps. It is also worth noting that the market is dominated by retail investors who are traditionally restrained when it comes to new strategies, which has hindered the market in the past.

“We work closely with the regulators in Saudi Arabia, where the CMA was very welcoming of the market expansion plans within securities financing,” says North. “This is a service we are looking at developing to ensure we can cover our clients’ interests with access to international and local lenders.”

While Saudi Arabia has a large market capitalisation, when comes to securities lending few countries in MENA are considered really active according to Societe Generale Prime Services head of liquidity management agency, Christian Regis.

“Several countries have over the last few years been working actively to build up their profile, like Qatar and Israel, but there is still more to be done,” he says. “While MENA-based asset owners have long been a very important part of the global securities lending market, most local markets have historically been restrictive when it comes to securities lending as a result of regulatory or operational reasons or market needs.”

Regulatory factors include both explicit restrictions (for instance, short selling is forbidden in most Middle East countries but permitted in others such as the UAE, albeit with some restrictions) or ‘by-default’ restrictions when rules don’t cover explicitly securities lending, thus creating legal or tax uncertainties. It must also be taken into account that several of the largest financial institutions in the region may also have to abide by their own Sharia rules.

Operational issues arise from legacy systems built to handle buy/sell flows but which are not suited for borrow/lend flows. Some markets are actively working on this, including the Tel Aviv Stock Exchange which has communicated on its plan to create a distributed ledger technology-based central securities lending platform market.

This being said, one regional source told us that we should not underestimate the dynamics at play which are pushing for greater development of local financial markets, including securities lending arrangements. Saudi Arabia is a good example with some local players setting up themselves for such activities, taking advantage of local
authorisation regimes.

In terms of repo, he refers to a varied playing field where some markets have had a structurally sound repo framework since the early 2000s and now have a highly active market whereas other MENA countries have substitutes to repos, albeit with a challenging legal and operational environment.

“Solving the multiple aspects required for the foundation of a fully-fledged repo market (accounting, tax, legal contract) has not yet happened in a meaningful sense throughout the region,” explains our source, who wished to remain anonymous. “The regional banks are active in the bilateral repo space, but still face a challenge to find new counterparts to finance GCC credit. Most of the banks are highly invested in GCC credit, which makes it hard for them to get new cash providers.”

He notes that the lending of securities is still a relatively uncommon activity in the Middle East, although lending and borrowing has - and should continue to - gain traction following recent announcements around the set up of regulated short selling facilities in Saudi Arabia, Abu Dhabi and Dubai.

“Lots of progress is being made but we are still at a fairly early stage compared to Europe, the US and Asia,” he says. “The operational framework to support money market transactions is still quite unevenly developed in MENA with a bias toward the primary markets and infrequent liquidity injection operations from the central banks.”

Ongoing restrictions on short-selling also hamper efforts, but there is a trend to allow this at least in a limited sense more recently, he adds. “There are a number of historical reasons for this - including central bank and regulatory policy - but the trend for advancement is clearly a positive one.”

As secondary market volume increases, repo and securities lending market CSDs will require upgrades in the services they provide (automation, risk management, IT and operational, real time connectivity). This presents an opportunity for those CSDs that already possess the required infrastructure to support the evolving market.

When asked to assess the regulatory environment for securities finance in MENA, our source observes that a number of global regulations that do not have a direct impact in the region carry a significant extraterritorial element.

“If we look at MiFID II/MiFIR trade reporting (to market), pre- and post-trade reporting requirements, quotes and details of executed transactions to be made publicly available in near real time applies to non-EU firms transacting OTC outside the EU with a non-EU branch of an EU investment firm,” he says.

MiFID and SFTR also carry transaction reporting requirements (to regulators) with executed transaction details - including legal entity identifiers - having to be reported to national competent authorities. This places a burden of responsibility on the MENA counterpart of an EU entity and has specific and potentially significant implications on sovereign wealth and other regional funds participating in securities lending programmes in the international markets.

To date, a number of these activities have been carried out on an anonymised basis, although the future of this type of arrangement looks uncertain.

EMIR also impacted banks in the region since all the countries are not ISDA-approved netting jurisdictions, so banks set up special purpose vehicles and are facing their repo counterparts from these SPVs.

“Positive trends include the launch of regulated short-selling facilities,” adds our source. “More broadly, moves such as Saudi Arabia’s efforts to modernise its stock market and its subsequent inclusion in the MSCI index will lead to the inflow of billions of dollars from money managers worldwide and help improve liquidity in the biggest stock market in MENA. Similar trends can be seen in the wider economy with reforms that help to boost overseas investment in Saudi Arabia, such as allowing 100% foreign ownership of companies in certain sectors.”

Securities finance transactions provide an alternative means of providing liquidity and yield to traditional lending methods, such as secured or margin loans, adds Brenda Bol, head of relationship management global securities financing at Clearstream.

“Deep and liquid secondary markets support liquidity and maturity transformation and have beneficial impacts across the economy,” she explains. “There is a massive potential for growth and we are still relatively early in the market, so the future looks exciting. The widespread implementation of repo frameworks in MENA countries should also assist with other structural and operational reform (such as legal framework, tax and accounting rules, and settlement infrastructure).”

As banks are forced to revaluate balance sheet-intensive activities in light of recent regulations, Bol is confident that opportunities will be created for the likes of sovereign wealth funds in MENA who can increase their activity in the repo and financing markets.

There is certainly further opportunity to be seen across MENA - such as in the UAE and Kuwait - although Saudi Arabia has garnered most interest from clients in recent times, says Citi’s North. “This is largely due to the MSCI and FTSE market announcements of upgrading the Tadawul. These changes indicate that the region is opening up its financial markets and that in time it will have the infrastructure, breadth and depth to accommodate international investor demand within the securities finance space.”

SocGen’s Regis agrees that there is considerable scope for growth. “Although the rhythm of progress has been slow, this is a very lively region with many sophisticated stakeholders (regulators, central banks, financial institutions positioning themselves with securities lending licences, advisors, vendors) who feel confident about pushing more and more for business-friendly solutions to meet local needs,” he says.

To get the full picture, one should not look only at securities lending initiatives but also more broadly at the efforts made to build more liquid local financial markets. This development, together with competition between local financial centres and growing issuance of local debts over time, is going to drive the emergence of new local liquidity pools.

“We should also not discount the possibility for innovative solutions to emerge in a relatively short period of time that would unlock growth, notably on fixed income assets,” concludes Regis.