Never has the need for a mature derivatives industry in the Middle East looked greater.

The request by Dubai World, the Gulf’s largest state-owned conglomerate, for a six month moratorium on servicing its debts on November 25 shocked world markets, tipping the FTSE 100 into its largest single day loss since March.

As investors exposed to the region scrambled to hedge themselves against further bad news, they may have noticed that the region’s stock exchanges offer virtually no suitable derivative instruments.

The inadequacy of local risk management routes looks stark in the light of the extreme challenges faced by investors in Dubai. Yet across the entire region, only one exchange, Nasdaq Dubai, offers equity or index futures. And these are limited to one future on the FTSE Nasdaq Dubai UAE 20 index, and a small clutch of futures on 20 UAE stocks.

Perversely, given the events of late November, the main problem is a lack of demand for equity derivatives. International investors, for whom exchanges like Nasdaq Dubai were set up within the foreigner-friendly offshore zone of the Dubai International Financial Centre (DIFC), bemoan the lack of liquidity.

Local investors, who dominate the region’s stockmarkets with about 75% of total trading, have formed the backbone of the limited equity derivative demand to date, but remain wary of these unfamiliar instruments.

“Local retail investors typically invest principally in equities, and have shown only limited interest in the principles of diversification so far,” says Nasdaq Dubai’s CEO, Jeff Singer.

Since the equity products were launched last November, interest has grown, but remained modest, despite Nasdaq Dubai’s efforts to educate local participants in the principles of mark-to-market valuation, margining, holding periods and expiry terms.

Investors are typically wealthy Gulf residents with $2m or $3m to trade, who churn their portfolios several times a week and are highly concentrated in equities.

Many have preferred to remain on the local exchanges, where they have established relationships with brokers, themselves reluctant to move into unfamiliar products or to offshore exchanges.

For Sharia-compliant investors, the unfamiliarity of derivatives is compounded by concerns that they fall foul of Islamic law.

Competing with Europe

Meanwhile, more sophisticated local investors familiar with the hedging and gearing benefits of derivatives often prefer to get their exposure in Europe. With many of the portfolio managers for these clients based in Zurich, some brokers selling derivatives in Dubai say they could do their jobs better from London. 

Nor are derivatives conveying access to Europe and the US through Gulf exchanges likely to prosper in the immediate future.

“Product providers looking to list an option on the S&P 500 to collect business from Middle Eastern investors are much better off doing it in London,” says Andrew Henderson, head of the financial services regulation group in the Dubai office of Clifford Chance.

And many foreign investors still prefer to seek Gulf exposure using contracts they engage in over the counter in London, rather than exchange-traded or bilateral agreements in the region.

This is evidenced in the story of Nasdaq Dubai. The exchange, originally the Dubai International Financial Exchange, was carefully located in the DIFC, an offshore Dubai territory aimed at foreign companies, with a benign local regulatory environment and near-zero corporate tax.

Yet the exchange’s volume has been driven more by local investors than by the foreign players for whom it was designed.

The other DIFC-based exchange, Dubai Gold and Commodities Exchange, has also been dominated by Middle Eastern participants, who generate some 80% of trading volume. The rest is from members in Europe, the US and east Asia.

The point was emphasised by Tom Healy, chief executive of the Abu Dhabi Securities Exchange, in November. The main threat to the success of the derivatives ADX is planning to list early next year, he announced, would not be competing products listed on Gulf exchanges, but banks hedging their risks OTC in London.

Power to the brokers

As they rely so heavily on local investors for growth in derivatives, the Gulf exchanges are having to negotiate the idiosyncrasies of the regional brokerage market. “Brokers typically do not link to multiple markets, preferring instead to concentrate on a single one,” says Gerhard Hametner, director of business development at brokerage MAC Capital, a member of Nasdaq Dubai.

But even if an established broker network and a secure retail investor base were in place, that would not necessarily bring local investors flocking to new derivative products when they are introduced.

The Abu Dhabi Securities Market (now the Abu Dhabi Securities Exchange) signed a cooperation agreement with NYSE Euronext in March 2008, under which the US-French group would supply technology and help it explore new products, such as stock and index futures.

But although it has a network of around 100 local brokers, much more than Nasdaq Dubai, ADX has made little progress in launching new products for them.

Plans to list the exchange’s first ETFs, originally mooted for November 2008, were pushed back to spring 2009, and now seem unlikely before early next year. Executives blame brokers’ and investors’ unfamiliarity with the structure.

Even if equity and index derivatives are listed next year on ADX, there will be no guarantee that the existing broker network can drum up volume.

The Emirates Securities and Commodities Authority, the UAE’s regulator, is unlikely to let 100 brokers unversed in the complex risks associated with futures and options begin selling them without proper certification.

“I think it’s likely that anyone who wants to trade will have to have a derivatives membership to indicate a satisfactory level of knowledge. Certainly they will have benefited from our work, but there will still be a large learning curve,” says Singer at Nasdaq Dubai. 

Foreign investors, meanwhile, quail in the face of the low volumes on Nasdaq Dubai and the neighbouring commodity exchanges like DGCX, when compared with more mature markets.

“Much of the problem boils down to the emergent nature of the cash market,” explains Hametner. “[Equities] volumes here have come off 70%-80% this year, and the derivatives flows depend on this base for their liquidity.”

Countries like the United Arab Emirates are still counted as fledgling rather than emerging markets by some market participants. Low demand from foreign investors means that cash products are so limited that there is not the bedrock to build derivatives depth. The latest ills of Dubai World will do little to help this.

Saudi hold-up

Meanwhile, stock index derivatives that would give international investors much-needed exposure to the entire Arabian region are stumbling on the obstacles to including a meaningful Saudi component.

The Tadawul, the Saudi stock exchange which accounts for 75% of the region’s equity trading and has a market capitalisation twice that of second placed Kuwait, is moving slowly.

Although the market was liberalised in 2006, and foreign investors can now own units in a fund, as well as government and corporate bonds, the only access to individual stocks is via swaps.

These are offered on the strictest terms: the investor must pay the broker entirely up front and the broker must buy the security entirely.

While this makes for a thriving OTC market, as leading international banks like HSBC, Bank of America Merrill Lynch and Morgan Stanley partner with local firms to meet foreign investors’ demand for such swaps, it does not promote price transparency – and that frustrates the sponsors of exchange-traded products seeking a Tadawul component.

Providers in London and the Gulf report significant demand from investors in London and the US for an index that takes in the entire Middle East and north African region. The challenge is to get enough pricing information to include Saudi Arabia.

Regulatory concerns

Structurally, too, Gulf exchanges continue to present obstacles to foreign investors. Many leading venues, for example, lack a globally accepted regulatory structure.

On the Qatar Exchange, the region’s third largest market, the proposed introduction of NYSE Euronext’s Universal Trading Platform technology by next September is being hampered by regulatory hurdles.

Foreign bankers complain that rules to prevent insider trading and govern mergers and acquisitions are weak, transparency is limited and there are still no laws allowing derivatives.

Meanwhile, the proposed unification of Qatar’s three financial regulators – the central bank, the Qatar Financial Markets Authority and the Qatar Financial Centre Regulatory Authority – seen as the cornerstone of reform, has not progressed at all since the start of the financial crisis.

Andre Went, appointed CEO of the Qatar Exchange in July, has conceded the need for reform and the likely long process of introducing derivatives.

The creation of the Dubai International Financial Centre, home of Nasdaq Dubai, has gone some way to creating an internationally acceptable legal and regulatory environment, circumventing the unreliable treatment of foreign investors in Dubai’s local courts, for example.

But several sticking points remain, market participants say. Getting a unique investor number is time-consuming and expensive. Know Your Investor rules are at odds with generally accepted practice in developed markets and require authentication by investors’ embassies in Dubai.

Promising starts

In light of these substantial structural and economic obstacles to the growth of exchange-traded derivatives, investors are a long way from finding local protection from shocks like that of Dubai World.

But these are very early days for the region’s exchanges. The Kuwait Stock Exchange, the region’s oldest market, only started serious trading in 1987, and closed again two years later for a time.

The onshore Dubai Financial Market and the Abu Dhabi Securities Exchange opened in 2000. And the Dubai Mercantile Exchange, which trades the region’s leading oil contract, has only been working since June 2007. Compare that with the Light Sweet Crude Oil Future, which has been established for more than 25 years at Nymex, founded in 1872.

As DME’s chief executive Thomas Leaver points out, the exchange’s Oman Crude Oil Future has the potential to threaten the major oil trading hubs in London and New York if it is widely adopted by Gulf producers.

And there are encouraging signs that the region’s exchanges may be capable of growing to provide a more mature derivatives market. 

Modest trading levels at Nasdaq Dubai, for example, mask sturdy performance in difficult conditions. Launched at the very trough of the global financial slump, last November, its growth has been strong. Monthly trading volume was around 6,000 contracts in the first quarter of this year; in April it grew to 7,000 and by October hit a record of 21,000, more than 50% up on September’s figure.

Getting the hedging habit

Behind the growth is a gradually widening range of investors. “This volume was driven initially by proprietary traders at local banks,” explains Jeff Singer. These investors were then joined by local rich private investors, the backbone of stockmarket flow in the region.

“Now we’re getting enquiries from the treasury departments of local banks in Dubai and Abu Dhabi, with mandates to look at derivatives as a hedge,” Singer says.

Local institutions, it seems, are ready to employ the equity contracts for hedging and risk management, and enquiries from local brokers concerning derivatives membership of the exchanges are increasing too.

Brokers, in turn, attribute the rising exchange-traded volumes to more involvement by international players who have become wary of the counterparty risk of OTC contracts.

“Our clients used the exchange-traded products as a low-cost and quick way back in to capture the recovery in the equity market this year,” explains an executive at one of Nasdaq Dubai’s trading members.

He also thinks the effort Nasdaq Dubai has put into marketing futures on UAE stocks has begun to show some results. “There is a growing awareness from local participants regarding the principles of hedging,” he says.

At neighbouring DGCX, too, considerable currency volatility this year has led to a rapid upturn in the use of futures to hedge exchange rate risk.

Currency futures volume at DGCX was 421,000 contracts in January-October 2009, far exceeding the 254,000 trades in the whole of 2008. Volume is still volatile from month to month, however, with more than half of this year’s volume coming in just three months – February, March and August.

DGCX’s West Texas Intermediate Light Sweet Crude Oil Future is also taking hold, with 105m barrels traded from May 2008, when it was launched, until December, and 214m in the first 10 months of 2009.

Other centres chase Dubai

And the fact that volumes on DGCX and Nasdaq Dubai are still small has done nothing to dampen the eagerness with which the region’s other exchanges are preparing listings.

Sources close to the Tadawul exchange who asked not to be named say that the exchange, the Saudi regulator and leading industry participants are working hard at preparing OTC and listed derivatives for early in the new year.

The exchanges of Abu Dhabi, Qatar and Bahrain have all committed to listing commodity or equity futures next year.

And the exposure of these exchanges to the worldwide trend of consolidation shows that the global exchange groups expect derivatives to thrive in the Middle East in the future.

CME Group owns 25% of the DME, with a further 20% of its equity held by a range of financial and energy firms including Goldman Sachs, Morgan Stanley and Shell.

Nasdaq OMX bought a 33% share in the Dubai International Financial Exchange in February 2008.

Then in June this year NYSE Euronext invested $200m for a 20% stake in Qatar Exchange. The deal was a cornerstone of the gas-rich state’s play to rival Dubai as the region’s financial hub.

In November new chief executive Andre Went, previously a senior executive at NYSE Euronext, restated QE’s ambitions to become an international and regional platform. Exchange-traded funds are planned for September 2010 and options and futures in 2011.

Meanwhile, this October, Bahrain Financial Exchange confirmed that, pending regulatory approval from the Central Bank of Bahrain, it planned to begin early in 2010 offering commodity and currency futures.

The new exchange is owned entirely by India’s Financial Technologies, which, in 2005, set up the DGCX, the Gulf’s first derivatives exchange.

These developments certainly indicate commitment from well-capitalised and experienced groups outside the region. In light of the uncertainties now surrounding Dubai World, and all the obstacles to getting new products really well accepted and actively used, experience and deep pockets are what is needed to develop liquidity in the region’s nascent local derivatives market.

When Andre Went predicted in early November that the job of developing derivatives on Qatar Exchange was one for the long term, it’s unlikely he expected events to prove him right quite so quickly.