Written by Charles Gubert

Charles Gubert

Foreign fund manager interest in Saudi Arabia is likely to remain muted in the short-term despite the recently enacted market liberalisation, although this could change substantially over time.

It was announced in June 2015 that the Tadawul – Saudi Arabia’s stock exchange – would allow Qualified Foreign Investors (QFIs) to invest in listed shares following rule changes enacted by the Capital Market Authority (CMA), the country’s financial services regulator. Despite the Tadawul having a market capitalisation of $590 billion (larger than that of Turkey, South Africa and Russia) and the Saudi market being one of the most liquid in the Middle East, few foreign managers appear to have taken the plunge despite widespread initial interest.

Bogart Miheaye, head of network management for Western Europe, Middle East and Africa at BNP Paribas Securities Services, acknowledged that while he had received a number of inquiries from clients about the viability of attaining QFI status in Saudi Arabia, this was yet to translate into a meaningful increase in trading volumes in the country, although he expected this to improve.

There remain are a number of investment restrictions in Saudi Arabia, something which has kept trading volumes low. QFIs cannot own in aggregate more than 20 per-cent of shares issued by a single listed company and individual QFIs are prohibited from owning more than five per-cent of shares in a single company. The regulator has said QFIs cannot comprise more than 10 per-cent of the overall stock market value.

“The Saudi Arabian market is very exciting, and diverse, and it offers enormous potential. However, trading volumes have so far remained low, because there continue to be a number of restrictions on share ownership. Furthermore, the regulations have only just been announced, and many firms are still digesting the implications of the rule changes,” said Ghadir Abu Leil-Cooper, head of the EMEA and global frontier markets equity team at Baring Asset Management.

Some predict inflows will become apparent when the MSCI upgrades Saudi Arabia from its Frontier Market Index to Emerging Market Index, a scenario which will facilitate investments from passive funds and exchange traded funds (ETFs). “When Saudi Arabia finally gets included in an MSCI Emerging Markets Index, the flows will be substantial,” commented George Birch Reynardson, portfolio manager at Somerset Capital Management, an emerging markets focused asset manager.

Other challenges do remain which are stymieing the emergence of Saudi Arabia as an investment destination.  The CMA has said banks, brokerages, securities firms, insurers or asset managers with assets greater than $5 billion or with more than five years securities or investment experience can attain QFI status. It also requires entities to be based in a jurisdiction which meets regulatory equivalence with that of Saudi Arabia.  The $5 billion Assets under Management (AuM) threshold is high, and could prevent emerging managers from investing in Saudi Arabia.

However, market reforms and progress have been noticeable in other areas, in what should help motivate foreign interest in Saudi Arabia. One of the biggest impediments to foreign fund managers investing in Saudi Arabia had been the lack of an independent custody model with securities often held in custody by local broker-dealers exposing firms to counterparty risks. This set-up could also result in local brokers executing unauthorised or fraudulent trades.

Reforms have been made which enable foreign investors to appoint an independent custodian instead of having to resort to a local broker. “The reforms provide greater safety to fund managers as it allows for segregation between assets held in custody between the brokers in Saudi Arabia and the custodian banks. This is a welcome development and will help Saudi Arabia mature as a region for investment,” said Arindam Das, regional head of HSBC Securities Services MENA.

Another hindrance to foreign investment is that Saudi Arabia currently operates a T+0 settlement mechanism whereby all transactions have to be pre-funded. Again, this exposes foreign investors to counterparty risk at local brokers and increases their cost of funding. The T+0 cycle also increases the scope for operational errors as trading mistakes cannot be cancelled prior to settlement.

“However, the Saudi Riyal is pegged to the US Dollar so firms are not exposed to material currency risk,” says Das.

There are also mechanisms foreign firms can use to work around the challenges of the T+0 settlement system. Where the custodian entity and the banking entity in Saudi Arabia is part of the same group, clients can reach out to the Saudi Arabian bank to provide credit facilities, thereby negating the obligation to pre-fund any transactions. “By using these credit lines from Saudi Arabian banks, foreign clients can simulate an extended synthetic settlement cycle,” highlighted Das. While the CMA is unlikely to make major changes to the settlement cycle in the foreseeable future, there are methods by which foreign financial institutions can circumvent the challenges of the T+0 system.

For more information about the Saudi market and the impact it may have on foreign investment, watch the video below with Arindam Das of HSBC
Filmed at our sister event, NeMa 2015