CLEARING & SETTLEMENT: The story behind the upgrades

IndicesWhen MSCI said it would promote Qatar and the UAE to emerging markets, investors in the region celebrated the promise of investment inflows. Behind the index provider’s decision were improvements in post-trade facilities in each country. George Mitton reports.

Investors in the Gulf waited six years for MSCI to upgrade the UAE to an emerging market. They waited so long, with so many disappointments, that by the beginning of this year it had become fashionable to say that entering the MSCI Emerging Market Index was not such a big deal after all. It was as if the bride had waited so long for a proposal, she decided she no longer cared for marriage.

Then, in June, MSCI said not only the UAE but Qatar too would be upgraded to emerging market status. Both countries, currently frontier markets, are due to be reclassified in the company’s semi-annual review in May 2014. There would be a wedding after all.

There were a number of exuberant predictions. Analysts at HSBC said the upgrades would lead to $800 million of inflows to the UAE and Qatar by passive funds automatically allocating to the countries.

Five times as much, an extra $4 billion, they said, could be invested by active managers who will take more interest in the countries now they are in the MSCI EM index.

The upgrades were greeted with such enthusiasm that MSCI’s simultaneous decision to downgrade Morocco from an emerging market to frontier market was generally downplayed. Yet behind the headlines, and invisibly supporting every optimistic prediction of inflows to the region, were a series of concrete improvements made by securities authorities in the UAE and Qatar. What were they, and what else needs to be done in the coming months?

The DVP modelMSCI said improvements in the delivery versus payment (DVP) model in both Qatar and the UAE were crucial factors in its decision to upgrade the two countries to emerging markets. DVP, which requires that cash payments be made prior to or simultaneously with the delivery of securities, significantly reduces credit risk in securities settlement by reducing the chance that deliveries or payments could be withheld – a great benefit in times of financial stress and low liquidity.

“International institutional investors recognised the improvements made by the Securities and Commodities Authority, the Dubai Financial Market and the Abu Dhabi Securities Exchange with respect to the DVP model,” says MSCI. It also praised the authorities in Doha and the Qatar Exchange for making progress in enhancing the operational efficiency of the DVP model in Qatar.

Another important addition to both countries was a proper false trade mechanism, which Qatar introduced in May 2012 and the UAE added in May 2013 having delayed plans made the previous year. The addition was important because it was expected to remove the need for large international investors to have segregated custody and trading accounts in both countries, a they precaution employed to reduce the risk from local brokers having unlimited access to trading accounts.

In the announcement of MSCI’s 2012 decision, in which the provider decided not to upgrade the UAE and Qatar, MSCI explained that this dual account structure resulted in operational burdens associated with needing to transfer shares from one account to another before trading.

Discussing Qatar in this year’s announcement, MSCI says: “Many international investors welcomed the introduction of a proper false trade mechanism that includes securities borrowing and lending facilities and expressed improved confidence in the safeguarding of investors’ assets. “Consequently, a number of international institutional investors have also started to migrate from the current dual-account structure to a single-account structure.”

An improvement specific to Qatar concerned foreign ownership limits. In its 2012 decision, MSCI said low foreign ownership limits were the major impediment to the country gaining emerging market status. It explained that, based on contemporary data, the total free float adjusted market capitalisation of the MSCI Qatar Index available to foreign investors was $10 billion. In an extreme scenario in which the Qatari equity market witnessed a net foreign capital inflow of $10 billion or more, the share of the free float available to foreign investors would fall to zero, making all index constituents ineligible and leading to the discontinuation of the MSCI Qatar Index.

Qatar has made progress on raising foreign ownership limits. MSCI says several companies have asked the Qatar Exchange to calculate their foreign ownership limits based on their total market capitalisation and not the free float market capitalisation, effectively increasing the shares available to foreign investors.

Yet MSCI says Qatar could do more. Although foreign ownership of Qatari equities is still below current limits, the limits are below average for an emerging market. The index says “the Qatari authorities should actively continue to increase [the limits] above 25% in order to mitigate potential issues arising from increasing foreign capital inflows”.

Asset managers and investors in the Gulf have been cheered by the MSCI upgrades. There is even the chance that the decisions will spur the region’s sleeping giant, Saudi Arabia, into action. After MSCI’s announcement, a number of opinion pieces in Saudi newspapers took the opportunity to criticise the securities authorities in their country for not speeding up the process of opening up to foreign institutional investment, a necessary precursor to joining MSCI’s frontier or emerging market indices. The implication of the upgrades, felt the commentators, was that Saudi Arabia was falling behind its neighbours.

The MSCI’s decision certainly opens up the Gulf to more global investment, and this will affect service providers as well as asset managers, says Sanjay Kannambadi, chief executive of BNY Mellon Clearing.

“You’re looking at potentially non-regional players increasing their investments in the region. For the local firms, it means they interact with clients outside the jurisdiction who have different regulations. Unless you’re very much a local player, only looking at the local currency and only serving local non-institutional players, it’s very important to be tuned in to the global marketplace.”

©2013 funds global mena

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