(DENNIS B MALLARI)
Investment banks are using derivative products not currently governed by the region’s regulators to allow foreign investors access to the UAE’s restricted markets, people involved in the transactions said. A spokesperson for the regulator, Securities and Commodities Authority, said a “new law is in the pipeline” to govern such contracts.
Stocks in the UAE are subject to foreign ownership restrictions ranging from 49 per cent for Arabtec to 100 per cent for etisalat. Many stocks are close to these limits, but the international appetite for the region’s equities has not been satiated after last year’s bull run.
Investor demand has pushed investment banks to devise “synthetic” ways to overcome this barrier.
The most common financial transaction used to get around the restriction, Emirates Business discovered, is through total return swaps – a derivative that allows the receiver (foreign investor) of the total return to gain exposure and benefit from an underlying asset (stocks restricted to UAE or GCC nationals) without actually owning it. This type of derivative – while not illegal – is not subject to oversight by SCA for now.
“Markets are very efficient – investors and market participants will find ways around regulations, and what you are seeing now is increasing demand for local paper. Because of the limitations and restrictions, banks are coming up with innovative structures to get around it,” a banker who uses these swaps said on condition of anonymity. The structure of these contracts is surprisingly simple – one source called them “plain vanilla derivatives”.
An investment bank that is willing to provide its clients access to closed or restricted positions can either find a local investor who holds shares in a certain company, or it can establish a Special Purpose Vehicle, or SPV, that is domiciled locally and can buy securities that are closed to foreign investors.
“The investment bank does a total return swap with the SPV, and then the sells that in turn to me or anybody else in the market.” The second contract essentially circumvents the ownership restrictions.
This synthetic financial arrangement gives the investor exposure to the upside without gaining physical ownership of the underlying company. “You are seeing this done in the UAE, in Saudi Arabia, in other places,” one asset manager said.
The local counterpart benefits from such arrangements because the investor does not buy the stock at the market rate – a spread is split between the investment bank and the local entity holding the securities. “The risk is on the investment bank.”
“As the end user,” a foreign investor said, “I am facing the credit risk of Merrill Lynch, or Goldman Sachs, so if someone runs away with the shares, Merrill [or Goldman] will have the problem. The local entity cannot sell without the explicit approval of the counterparty, so I am only facing the credit risk of the investment bank.”
Merril Lynch and Goldman Sachs did not respond to questions. One local investment bank said that it enters such contracts on a “one-off basis”.
“We do look at these things because we think we can manage risk well and are willing to take proprietary risk, when it makes sense,” the banker said.
The rationale for using the swap is clear. The diversification benefit of being in the GCC is very high because the correlation with the developed world and emerging markets as measured by the MSCI Emerging Markets index is very low. The region’s strong economies, attractive valuations, and the diversification benefits coupled with a probable recession in the US, has led to increased interest from foreign investors, and more innovative structures to attract their capital.
Those involved are aware of the precariousness of this activity, and made similar calls for further deregulation of equity markets in terms of foreign ownership, and more regulation as far as transparency and disclosure are concerned.
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