Derivatives Market in GCC

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Derivatives Market in GCC 03 - Apr - 2007

Derivatives Market in GCC Cutting a (very) long market short Kuwait Financial Center (Markaz) has recently published a report analyzing the need to introduce and encourage the growth of derivatives in the GCC capital markets.

According to M.R. Raghu & Hussein Zeineddine, authors of the report, most of the GCC capital markets (except Kuwait) haven’t yet started the process of introducing derivatives products In spite of having an advanced trading infrastructure.

Markaz previous research (Managing GCC Volatility) has established the fact that GCC stock markets are the most volatile in the world. Given the growing size and volatility of GCC capital markets, the road ahead is clearly to have a complete market structure that will enable stakeholders cost-effectively raise capital and manage risk. A key missing link in this process, according to the report, is the derivatives segment. GCC stocks markets have remained a “long-only” market for a very long time. Across the globe derivatives, especially Options and Futures, have played a very crucial role in capital market development.

The Equity Derivatives market has now reached a size of $114.1 trillion. The presence of strong equity culture along with limitations of GCC capital markets provides a compelling platform for introduction of a derivatives market in the GCC region. Strategic investors can unlock their potential without diluting their stake. Institutional investors would welcome this as they are familiar with using such instruments for fixed income and other instruments. GCC markets lack both breadth and depth of the market. In terms of number of companies, GCC region hosts about 550 companies as of the end of year 2006. When measured against the size of the market (market capitalization), it can be seen that the growth in the number of companies is muted relative to the growth in market size. The GCC markets are classified as “long only markets” where trading strategies are limited to “buying when market is expected to go up and liquidating when it is expected to fall down”. In fact the absence of the short-sale activities in such markets does not allow investors to enhance their returns during down trend.

Thus investors are left with no choice but to liquidate their positions which on one hand will exacerbate the effect of the downfall while on the other hand will adversely affect the liquidity of the market. The size of the decrease in the liquidity levels is driven to a great extent by the size of the corresponding downfall. Thus if the downfall is very sharp the liquidity could be completely drained- out. Kuwaiti market during the period 2005 to 2006 is a good example. Although the Kuwaiti market is characterized by the presence of a wide diversity of sectors with a major presence for the blue chip companies such as NBK, MTC, and PWC…etc, the market was not able to sustain liquidity during the correction movement in February 06. Investors as well as fund managers, in the lack of the hedging tools such as the put options, were desperately trying to liquidate their positions while the market was heading down and “draining out” the liquidity with it.

This results in a Domino effect. Most of the GCC stock markets are speculative as well, though in varying degrees. While volumes are concentrated in few stocks, even these are among penny stocks. The report explains some application areas for derivatives like short-selling, options, structured products, etc.

Short-selling: A short sale is a sale of securities which the seller dos not own at the time of affecting a sale. If short-selling is permitted, market participants will sell over-valued stocks which will reduce the market price and improve pricing efficiency. In the case of short-selling, the short seller has to borrow the stocks sold short till the entire process till he returns the borrowed stock. While there is nothing undesirable about short-selling, history is replete with abuses on short-selling making the need to regulate this more than what is necessary.

Options: A covered call is an option strategy that involves writing a call option on a stock that the investor owns. A protective put is an option strategy that involves buying a put option on a stock that the investor owns. Both covered call and protective put can find extensive application in the GCC region. The high level of strategic holding by families in leading blue chip companies provides excellent ground for generating income through writing call options. Similarly, large exposure to GCC stock market can be effectively protected through buying put options.

Volatility Trading: Traditional equity trading is mainly based on speculating the market movement of the underlying equity. Volatility trading entails strategies designed to speculate on changes in the volatility of the market rather than on its direction. Volatility is traded through many products or tools of which the simplest and most famous is options. An option is a product which can provide investors with plenty of opportunities and trading alternatives to generate returns under almost all market conditions.

Structured Products: A structured product is a financial instrument that mostly combines a conventional asset class such as equity or a fixed income security with a derivative instrument. Structured products are usually designed to meet the investors' specific needs taking into consideration the existing market conditions. There are many advantages for investing in the structured products which include capital protection, enhanced returns, controlling risk (volatility), portfolio diversification, utilize current market trend, etc. A capital guaranteed note is a note which guarantees the investor a certain percentage of capital while giving a chance to participate in the upside movement of the value of an underlying stock or basket or index. The percentage of the capital guaranteed (C %) and the upside participation rate (R %) can be structured based on investor preference. The higher the percentage of capital guaranteed (C %), the lower the participation rate (R %) Constant Proportion Portfolio Insurance (CPPI) is an investment strategy whereby funds are allocated dynamically between two types of assets, a risky growth asset such as equities and a non-risky asset like bonds, cash etc. The allocation is determined by a prescribed formula and designed to preserve capital at a future date. CPPI has played a crucial role in the structured equity markets. CPPI provides capital protection by reducing equity exposure in declining markets and increasing it in rising markets.

At maturity, the investor gets the capital guaranteed plus appreciation in the dynamic basket invested both in risky and risk free asset. Current Status: Trading options did not exist in the Middle East Stock Exchanges or in the Arab Stock Exchanges until Kuwait Financial Centre S.A.K. “Markaz” initiated a proposal to provide the options service in Kuwait Stock Exchange in year 2002. Markaz suggested establishing a system for trading in options through a Fund viz., “Forsa Fund” to work as a market maker for options trading in the first stage. In March 2005, KSE allowed Call options to be traded by Forsa Fund. Trading on the first day (March 28, 2005) was on 13 stocks and 75 contracts with a total strike value of KD 2,378,150.000.

Options value and volume traded fell during year 2006 compared to year 2005 mainly on the back of weak market sentiment. Forsa option contracts are currently traded in the secondary market on 45 listed stocks in the Kuwait Stock Exchange. It should be noted that KSE presently permits only call options. According to the rules and regulations for trading forward contracts at the Kuwait Stock Exchange, a forward contract represents an agreement between the forward buyer (trader) and the forward seller (market maker) in which the buyer agrees to buy a certain number of shares from the seller for a fixed price (equity spot price) during a future period of time. Currently the forward market offers contracts for 3, 6, 9 and 12 month periods and operates after the spot trading session (12:45PM to 01:15PM).

This market is very suitable to the KSE trading environment where the majority of the speculators buy forward contracts to gain financial leverage, and if they make money they sell the shares out in the spot market thereby settling the balance payment before maturity of the contract. Based on historical figures and KSE trading atmosphere, 75% - 85% investors offsets/early settle their contracts in spot market. The futures market operates in a completely similar manner as the forward market except that the future market operates during the spot trading session (9:30AM to 12:15PM). Unlike options market where there is only one market maker (Markaz), the futures and forward market enjoys many players.

Road Map: A major motivation for introduction and growth of derivatives in the GCC region is that it can enable transfer of risk between individuals and firms in the economy. More simply, it is like buying and selling insurance. While the risk-averse investor buys insurance, a risk-seeking investor sells the insurance. Past researches have produced very encouraging findings.

In terms of an action plan for GCC regulators, the report suggests the following:
1. Set up a Derivatives Exchange: Exchange-Traded Derivatives can be a solid basis to start the process than OTC. Derivatives which trade on an exchange are called “Exchange-Traded Derivatives”, while a derivative contract which is privately negotiated is called an OTC derivative. Trades on an exchange generally take place with anonymity and go through a clearing corporation while that of OTC do not. Hence, forming a derivatives exchange will be the most important first step to be taken.
2. Draft Regulatory Framework: GCC capital markets are neither emerging markets (from an economic strength point of view) nor a developed market from a market microstructure point of view. Hence, it is pertinent to form a committee of highly experienced and qualified people drawn from various financial institutions to come up with a customized regulatory framework for the orderly governance of derivatives. A lot can be learned from the experience of some of the Asian capital markets that have successfully set-up such frameworks.
3. Introduce Index Equity Derivatives: Equity derivatives are the most common worldwide, especially index futures followed by index options and security-specific options. Internationally, options on individual stocks are common; futures on individual stocks are not that common. Index based equity derivatives (options and futures) are quite popular among investors as they are excellent hedging tools and also present few regulatory headaches when compared to leveraged trading on individual stocks. This has led to regulatory encouragement of index futures and discouragement against futures on individuals stocks.
4. Introduce Short-Selling: As we explained earlier, market efficiency can be significantly enhanced through introduction of short-selling. Just as we have margin requirements on the long-side, we can have similar regulatory checks to prevent misuse of this important tool. If dealt with properly, short-sales can check bear-side excesses in a falling market.
5. Introduce Stock Equity Derivatives: With a well stabilized index based equity derivatives, the risks of stock-based equity derivatives is well contained. As we can see from the above, except for Kuwait none of the other GCC markets have taken any of the steps suggested above. Even in the case of Kuwait, introduction of derivatives in the form of call options did not adhere to a structured process as explained above.

There are still gaps to be addressed. ### About Markaz Kuwait Financial Centre 'Markaz', with total assets under management of over KD1.20 billion as of December 31, 2006, was established in 1974 has become one of the leading asset management and investment banking institutions in the Arabian Gulf Region. Markaz was listed on the Kuwait Stock Exchange (KSE) in 1997; and was recently awarded a BBB+ corporate rating by Capital Intelligence Ltd.