The Middle East 色花堂Finance panel: Part three
10 December 2024
In the third instalment of a three-part series, industry experts discuss the Middle East鈥檚 key SBL models, the coexistence between conventional and Islamic finance, as well as the importance of responsible growth
Image: stock.adobe.com/swisshippo
Moderator
Gabriele Frediani, Head of Development and Market Infrastructure Coverage, Europe
Liquidity & Sustainability Facility
Panellists
Sarah Alothman, Managing Director, Head of 色花堂Services, Riyad Capital
Dimitri Arlando, Director, EMEA Sales, EquiLend
Darren Crowther, General Manager, 色花堂Finance and Collateral Management, Broadridge
Jalal Faruki, Head of 色花堂Services & Custody, SNB Capital
Elie Geagea, Head of Equity Derivatives Solutions EMEA, HSBC
Andrew Geggus, Global Head of Agency 色花堂Lending, BNP Paribas
Andrew Stephen, Executive Director, Buyside Trading Services, J.P. Morgan
Saudi Arabia is a spectacular example of 鈥榳here there鈥檚 a will there鈥檚 a way鈥�. The region is growing and looks to continue its growth. Can you talk to me about the region鈥檚 three SBL models?
Jalal Faruki: These are the models that you see active at different types of firms and service providers. The first one, or one that we usually see, is agency lending. It has the least amount of risk and balance sheet impact on participants, and it's a model that we see most active in developed markets. It's the model that we see our clients use when they lend their international assets.
Another model that we've seen, that has a place in Saudi and will continue to is a pooled principal model. This is a model that we use 鈥� we're facing multiple qualified clients as principal, we're borrowing shares and then onward lending to another counterparty or client. That model allows us to face multiple counterparties through SNB Capital. They're generally comfortable with our balance sheet and our risk, and it allows people who maybe wouldn't have access to those counterparties directly, to enter into those transactions through us.
The last model is what we started seeing initially when the stock loan regulations came out, which is purely bilateral trades. The challenge with bilateral trades is if one side wants to return a call back, it's hard to get those securities reused or to substitute that loan out. Whereas in agency lending and pooled principal, even if the lender wants those shares back, we can substitute that out with another lender, potentially in the queue or in the pool. It therefore gives borrowers a more stable inventory and supply.
From a practical perspective, we think all of these models need to exist in Saudi Arabia. When you look at demographics, Saudi is similar to some of the large Asian markets, where you have 60, 70, or 80 per cent ownership and activity from retail and high net worth investors 鈥� it used to be 90 per cent. That investor isn't going to be able to go into the institutional agency lending programmes. They need a full principal programme to be able to work. We think all of those models are going to be active in different sets of lenders and different sets of borrowers in the Saudi market.
Andrew Stephen: We talked earlier about client and investor education when talking to a market which is relatively unfamiliar with the practice, the agency model carries the least risk. The benefits of outsourcing to an agent lender, namely the rules and limits that guardrail the programme, make it easier to enter into the market.
Since relocating from London to the region, I have started to receive messages from my bank telling me where to invest from an IPO perspective 鈥� this is not something you would see in the UK. We've seen demand for what we call the 鈥榓ggregator鈥� model, where you have the broker, or the client's broker, and they almost act as the principal, but through agency structure. Essentially, they sit at the top and aggregate all of that retail flow, and then face off as the lender or the beneficial owner, and then make their assets available. We've had a lot of success with that model in Europe and in Asia.
The Gulf Cooperation Council (GCC) countries are primed for this model. There are retail brokers out there providing access to the stock market to their underlying retail clients. If we can tap in and see that as the beneficial owner, we can access a large part of the supply in the market, while facing off to only one client.
Faruki: The challenge in Saudi is that, for me to enter into a securities lending trade with a counterparty, if I'm not a qualified investor, I have to have a lending agent. We couldn't act as lending agent and principal at the same time, so we have to only face lenders who are qualified 鈥� which is a relatively low asset test, so around SAR 5 million (US$1.3 million). A lot of clients meet that requirement, and that's what's allowing us to tap into a different liquidity pool than an agency model might ever be able to attract.
Dimitri Arlando: From a global perspective, we鈥檙e seeing fully paid lending 鈥� or client asset lending as EquiLend calls it 鈥� as a huge growth market for us. It started with the likes of Robinhood in the US, and now we are seeing growth in lending retail held assets increase in Europe and Asia as well. The number of conversations I鈥檝e had with people in this region about fully paid lending is growing each week.
Technology has a huge part to play in that, because the challenge with mobilising that supply, where retail brokers could have 1000s or millions of underlying accounts, is trying to aggregate all of those positions up into something that a broker-dealer is going to be happy to borrow from and then distributing the income and corporate actions back down to the retail clients. The technology exists for that to happen today.
Darren Crowther: We're seeing the same types of requests for fully paid lending. The complexity comes in from the extra layer of allocation, feed distribution, and collateral allocation that you need to take to underlying retail investors, with small amounts of shares in each one. Depending on where you鈥檙e based in the world, there may be a requirement, in some cases, to report to the regulator about those trades, something that was never there three or four years ago. It takes a real technology shift to be able to do that, but the benefit that the firms get shows in the additional revenue. That upfront investment in the technology allows the additional revenue to come in.
Stephen: It's well known that the securities lending market, for a very long time, has been significantly oversupplied in terms of lendable versus on-loan. It's these sorts of things that give you a new source of supply, allowing you to drive that on-loan balance up, without necessarily increasing the lendable.
Arlando: Those pools of assets are often more in demand from the broker-dealer community, because they are quite unique. We see it in Scandinavia as well, where some of these lenders in Scandinavia, who have access to domestic owned supply, they鈥檙e immediately in demand from the broker-dealer community, because what they鈥檙e bringing to the table is very different from what they鈥檙e currently seeing in supply terms.
Faruki: The next thing you have to look at is the demand. It's great that we can capture all of the supply, but if there isn't enough demand, and there aren't products that need those shares as a borrower, you're not going to have enough to have a fair and balanced market.
While they might look great on the surface, market makers are the worst clients for stock loan, because they take the stock for a day or two, and they return it. From a lender's perspective, where it's a new market, and you're trying to get them active, they don't want to lend their shares out for a day or two, that's not going to generate anything meaningful for them.
Then you have to start looking and ask yourself: who are the kinds of counterparties that would be good borrowers, that would have good utilisation, that would be paying good rates. And then you start looking at long-short and at other strategies that have those kinds of horizons. In the region, there's a huge amount of funds now that are set up with regional bases. They're not just trading globally, they're coming to Saudi, they're coming to other regional markets, and seeing how they can be a part of the capital market activity. That includes initial public offerings (IPOs), stock loan, and even strategies that we don't see elsewhere, like corporate action arbitrage, and merger arbitrage 鈥� we've started seeing demand to borrow that didn't exist two years ago.
Elie Geagea: Indeed demand is picking up. The demand pick-up is driven by new asset managers coming to the region and by the new economic environment. We are in an environment where volatility is observed in the equity market, the equity market is no longer a one-direction market that has been a bullish market over a decade. Volatility is here, so investors and asset managers are looking for hedging solutions. And for hedging solutions, you need an efficient SBL market.
Inflation is here, asset managers are looking more and more for yield pickup solutions and share lending is one of them. You need an efficient SBL market. The low rate era is over. Three or four years ago, asset managers had access to cash in a free and abundant way. It's no longer the case, we are back to a relatively high rate environment. Funding is costly now, so investors are looking for a cheaper and optimised financing solution. This can be achieved through derivative instruments, which can not be implemented without an operational SBL framework. Given the above, the borrow need is picking up, hence the need for diversified and stable supply.
Sarah Alothman: Speaking in general about the growth here in Saudi 鈥� capital markets activities have grown exponentially in the recent five years, and this is due to the changes that are happening in the market. This includes the introduction of the qualified foreign investors, the independent custody model, the listing of the IPOs, post-trade enhancements, the introduction of CCPs and CSDs. This has also helped position the Saudi exchange, or Tadawul, to be the 10th largest global exchange by market capitalisation. This has encouraged strong demand and growth, both from the market and the investor side.
Andrew Geggus: That has a knock-on effect as well. All of those points have then led more investors on the buy side to start taking positions in the market. We hear from all of our borrowers that they're having conversations with their clients about access to the region, and, particularly, access to Saudi Arabia. While we said that we took a leap of faith to try and go live in lending in Saudi Arabia, it was only because we are getting a huge knock on the door from all of our borrowers, and they're getting the same conversation from their clients.
Crowther: We've had to work hard with our clients on understanding the cost of getting into the market to begin with. The build and implement stage versus the run and operate stage, are quite different. There鈥檚 an upfront build integration cost to execute trade number one. There is then an ongoing run cost 鈥� going back to Andrew's point around operations: how do you manage the book? How do you manage the risk? Do you do it out of the global team? Do you have a local team here on the ground? Is there an investment to be made or not?
All of that drives back to the quality of the assets that are available for lending and the utilisation of those. We've worked with a number of clients to look at their business cases and quite a lot of the work that we do at the start of any engagement with a client, is understanding what their operating model is going to be, how they're going to service things, and helping them to cost out what that would look like technology wise.
What are the dangers here? What does this community need to be aware of to make sure that this journey into the Middle East continues as a success story?
Arlando: Firms need to make sure that whatever regulations we鈥檙e putting in place and whatever product design we鈥檙e putting in place is consistent, and essentially leads to efficiency in the market. That efficiency in the market is key, because borrowers are more likely to pay up when it鈥檚 more efficient to them. So globally, whichever market you鈥檙e looking at, if there鈥檚 no borrow demand, there鈥檚 no market.
The one thing that borrowers are really interested in is analytics and data around their trades, trading activity, and their counterparties. They are more likely to trade and engage with counterparties that are efficient to them, because they鈥檙e under cost constraints as well. It鈥檚 important to ensure that, yes, we鈥檙e growing this market, but when we鈥檙e looking at how to grow it and taking it to the next step and beyond 鈥� which we all agree is going to happen here 鈥� that point of efficiency and doing things with best practice in mind, is important.
What is the outlook for the region? Is Saudi full steam ahead and will the other Middle Eastern markets follow? Are we looking at a future pan-GCC market?
Faruki: Market standardisation is a key point. If you look at agreements, operating models, and even cutoffs for required values (RQVs) 鈥� these are all critical things. We joined the International 色花堂Lending Association (ISLA) a couple years ago to learn more about securities finance and how it works globally. We took a lot of positive feedback from the global participants and tried to say: there's clearly market standards and practices that they're willing to share with us and to help us learn and develop our own capabilities in our own market. We have to take the same approach now for market participants, we have to be willing to share information, to share ideas on how we do things, and to try to come to a common standard and practice.
At the end of the day, if I have my own ecosystem, and another custodian has theirs, and the international banks have a third one, it's going to be very hard to do things between different custodians or counterparties. It's not going to allow the market to be efficient. There will be different pricing, depending on how you're documented, depending on how you're set up. Market standardisation is the key thing, and we have to put our own business interests aside and ask: how do we do this in a way that benefits everybody and grows the market?
Geagea: Before covering the SBL outlook part, I would like to go back to the starting point. In 2013-14, there was a will from several countries in the region to increase liquidity and bring foreign investments into GCC markets. Many GCC countries started discussing and preparing for index inclusion. In 2018-19, many GCC countries were included to the emerging and global indices. The index inclusion brought foreign investments and increased liquidity on the secondary market. On the primary side, IPOs in the region were very active and increased local and foreign interest in investing into GCC markets. So in terms of cash equity, work has been done on both the secondary and the primary side.
With increased liquidity and higher foreign investments, there was a growing need to build an efficient capital market. Once you bring liquidity and capacity, the second step is to build efficiency. For an efficient capital market, you need to have three pillars, which are: liquidity, an operational derivative market, and an operational SBL market. For any capital market growth plan, whether in Saudi or other GCC countries, to have an efficient capital market, you need those three pillars
HSBC, as a well-established multinational bank in the region, has started working on those pillars since the early beginning and we are fully confident that the growth story will continue, but growth needs to be done in a smooth and responsible way.
Stephen: Given the potential, across various sectors, of the GCC, I think it would be unwise to bet against the region. In the realm of securities finance and lending, it is crucial for market practitioners, global custodians, and agent lenders, to focus on developing market depth. There's a risk that we assume Saudi is done, move onto the likes of the UAE, Qatar, and Kuwait, and spread ourselves too thin.
Instead, we should double-down on Saudi, for example, and analyse all the different opportunities and the different mechanisms and services that we can put in place to help our clients. As we build up the lending side, we want to build out the ability to take Saudi domestic equities, for example, as collateral.
Foreign banks will face limitations in their business activities if they cannot reuse their assets 鈥� it is our responsibility to develop solutions that complete the system in Saudi Arabia, before progressing to the other markets. While it is, of course, important to stay informed on the developments in other GCC countries, the priority should first and foremost be Saudi Arabia.
Crowther: On the banking side, it makes perfect sense, because you want to make sure you've got something solid, a foundation for that business going forward. Because of the nature of all of the other countries trying to keep pace or catch up, from a technology perspective, we will have to service all of the regions, no matter where they are in their securities finance journey.
The key success is interoperability. Andrew has mentioned it a couple of times and it's spot on 鈥� whether that's at the pre-trade level or at the data vendor level, or even the CSD level, providing all of those capabilities is key to the evolution. If firms successfully bring on more clients, if they can't do them at volume because of constraints around technology, the whole thing falls apart.
So as a service provider, we need to be thinking ahead to not just next week's revenue, but one year, two years, and three years ahead to make sure all of those things are available, and then the market will be a bit more fluid.
Alothman: Saudi Arabia has done more work and input effort into the region. And, eventually, there have been more inflows into the market. The exchange is also catching up with the global market capitalisation. I'm optimistic, so I would say that there is more exponential growth within the next five years in respect to SBL. As Elie mentioned, liquidity is a key. This has been ticked and has been picking up also in the market.
There is an opportunity, there is growth coming, and there have been so many tremendous changes in the market from the inclusion of MSCI back in June 2018 to look at where we are today, qualified foreign investors holding is US$88 billion as of August 2024. Introducing new products to the market will attract more investors, and so we will see more demand in the market.
In regard to the coexistence between conventional and Islamic finance, where are we today?
Geagea: A big percentage of assets, if not the biggest, is held by Islamic financial institutions. If we look at fixed income repo, the Islamic offering has massively picked up in the recent three years. I don't see that SBL will be an exception. As for any OTC transaction, an Islamic SBL agreement needs to be done between two counterparties, and any Sharia discussion needs to be validated by the two counterparties separately.
The key element in the Islamic framework is standardisation. In the Islamic OTC derivatives world, we witnessed a shift toward centralised Islamic guidance and practices of the operation model of any Islamic OTC transaction. Islamic documentations and negotiation refers to the Tahawwut Master Agreement (TMA), a well-known reference and acknowledged across the region. We definitely need something similar in the Islamic SBL world. Standardisation is even a request from international organisations like the ISLA. ISLA is encouraging stakeholders in the Middle East to have a common Islamic regulation and practices, which can be acknowledged by local participants.
Faruki: From what we see right now in supply and demand, it's maybe not important from a borrower side, where lots of the borrowers are international. But from the supply side it's critical that this gets developed, because the majority of clients that we deal with are looking at transacting in a Sharia compliant manner. We've gotten clear feedback that there's ways to do that. But it's just getting the standard documentation, the standard terms, standard way that those trades are processed, to make sure that they are complying with those rules and with that guidance.
Geggus: It's a consideration that we have to take on board when we're reviewing the opportunity of the region as a whole. This is a big element of transacting within the region. The work ISLA is doing is fantastic, and trade bodies like that can really help the market to get a consensus view into certain items in the region. Hopefully we will get some sort of standardisation around that point.
Crowther: From my perspective, over the last couple of years, we've worked with a client in Saudi to extend the capability of the platform to allow them to trade on a Sunday 鈥� which was new for us. Likewise, Bursa Malaysia put in place a strong template around how Islamic securities finance will work for them, which drove system changes and increased system capabilities to match. Any other regulation or standardisation that comes in, in any place, you follow that same suit.
Faruki: It goes back to the question of, is there one way of doing securities lending that works for every single client and every counterparty? And I think the answer is no. You're going to have these different pockets of liquidity and supply. The challenge now is that it's such a new market, we still can't identify what those will look like and what they will be. Just as we're saying clients in Saudi or other markets in the region are interested in lending securities, I'm sure there's maybe not as many, but there's a good deal of clients that are also interested in borrowing securities, and taking certain positions that they weren't able to take previously.
These are all parts of the market developing, and you'll have those different pockets of maybe Sharia compliant only, and ones that face international borrowers. There's also a lot of other points that will come up, like withholding tax, dividend treatment, voting, ect. All are going to create different models and different approaches, but as long as you have some agreement and standardisation, that's what will help to mitigate those risks disrupting the market.
Crowther: That's absolutely no different from any region鈥檚 client requirements. Whether it's a UK-based organisation, or a scandic organisation, they've all got their own rules and regulations. Islamic securities finance is just another client set that we all have to deal with.
Geggus: It comes back to the responsible growth point that was made earlier 鈥� we want this to grow, we want it to be a success, but it has to be done in a responsible way that takes into account the views of the regulators and the trade bodies, and that we work as a collaborative to grow this economy and build the market, rather than try and go alone and and cause issues. So it's all about responsible growth.
Gabriele Frediani, Head of Development and Market Infrastructure Coverage, Europe
Liquidity & Sustainability Facility
Panellists
Sarah Alothman, Managing Director, Head of 色花堂Services, Riyad Capital
Dimitri Arlando, Director, EMEA Sales, EquiLend
Darren Crowther, General Manager, 色花堂Finance and Collateral Management, Broadridge
Jalal Faruki, Head of 色花堂Services & Custody, SNB Capital
Elie Geagea, Head of Equity Derivatives Solutions EMEA, HSBC
Andrew Geggus, Global Head of Agency 色花堂Lending, BNP Paribas
Andrew Stephen, Executive Director, Buyside Trading Services, J.P. Morgan
Saudi Arabia is a spectacular example of 鈥榳here there鈥檚 a will there鈥檚 a way鈥�. The region is growing and looks to continue its growth. Can you talk to me about the region鈥檚 three SBL models?
Jalal Faruki: These are the models that you see active at different types of firms and service providers. The first one, or one that we usually see, is agency lending. It has the least amount of risk and balance sheet impact on participants, and it's a model that we see most active in developed markets. It's the model that we see our clients use when they lend their international assets.
Another model that we've seen, that has a place in Saudi and will continue to is a pooled principal model. This is a model that we use 鈥� we're facing multiple qualified clients as principal, we're borrowing shares and then onward lending to another counterparty or client. That model allows us to face multiple counterparties through SNB Capital. They're generally comfortable with our balance sheet and our risk, and it allows people who maybe wouldn't have access to those counterparties directly, to enter into those transactions through us.
The last model is what we started seeing initially when the stock loan regulations came out, which is purely bilateral trades. The challenge with bilateral trades is if one side wants to return a call back, it's hard to get those securities reused or to substitute that loan out. Whereas in agency lending and pooled principal, even if the lender wants those shares back, we can substitute that out with another lender, potentially in the queue or in the pool. It therefore gives borrowers a more stable inventory and supply.
From a practical perspective, we think all of these models need to exist in Saudi Arabia. When you look at demographics, Saudi is similar to some of the large Asian markets, where you have 60, 70, or 80 per cent ownership and activity from retail and high net worth investors 鈥� it used to be 90 per cent. That investor isn't going to be able to go into the institutional agency lending programmes. They need a full principal programme to be able to work. We think all of those models are going to be active in different sets of lenders and different sets of borrowers in the Saudi market.
Andrew Stephen: We talked earlier about client and investor education when talking to a market which is relatively unfamiliar with the practice, the agency model carries the least risk. The benefits of outsourcing to an agent lender, namely the rules and limits that guardrail the programme, make it easier to enter into the market.
Since relocating from London to the region, I have started to receive messages from my bank telling me where to invest from an IPO perspective 鈥� this is not something you would see in the UK. We've seen demand for what we call the 鈥榓ggregator鈥� model, where you have the broker, or the client's broker, and they almost act as the principal, but through agency structure. Essentially, they sit at the top and aggregate all of that retail flow, and then face off as the lender or the beneficial owner, and then make their assets available. We've had a lot of success with that model in Europe and in Asia.
The Gulf Cooperation Council (GCC) countries are primed for this model. There are retail brokers out there providing access to the stock market to their underlying retail clients. If we can tap in and see that as the beneficial owner, we can access a large part of the supply in the market, while facing off to only one client.
Faruki: The challenge in Saudi is that, for me to enter into a securities lending trade with a counterparty, if I'm not a qualified investor, I have to have a lending agent. We couldn't act as lending agent and principal at the same time, so we have to only face lenders who are qualified 鈥� which is a relatively low asset test, so around SAR 5 million (US$1.3 million). A lot of clients meet that requirement, and that's what's allowing us to tap into a different liquidity pool than an agency model might ever be able to attract.
Dimitri Arlando: From a global perspective, we鈥檙e seeing fully paid lending 鈥� or client asset lending as EquiLend calls it 鈥� as a huge growth market for us. It started with the likes of Robinhood in the US, and now we are seeing growth in lending retail held assets increase in Europe and Asia as well. The number of conversations I鈥檝e had with people in this region about fully paid lending is growing each week.
Technology has a huge part to play in that, because the challenge with mobilising that supply, where retail brokers could have 1000s or millions of underlying accounts, is trying to aggregate all of those positions up into something that a broker-dealer is going to be happy to borrow from and then distributing the income and corporate actions back down to the retail clients. The technology exists for that to happen today.
Darren Crowther: We're seeing the same types of requests for fully paid lending. The complexity comes in from the extra layer of allocation, feed distribution, and collateral allocation that you need to take to underlying retail investors, with small amounts of shares in each one. Depending on where you鈥檙e based in the world, there may be a requirement, in some cases, to report to the regulator about those trades, something that was never there three or four years ago. It takes a real technology shift to be able to do that, but the benefit that the firms get shows in the additional revenue. That upfront investment in the technology allows the additional revenue to come in.
Stephen: It's well known that the securities lending market, for a very long time, has been significantly oversupplied in terms of lendable versus on-loan. It's these sorts of things that give you a new source of supply, allowing you to drive that on-loan balance up, without necessarily increasing the lendable.
Arlando: Those pools of assets are often more in demand from the broker-dealer community, because they are quite unique. We see it in Scandinavia as well, where some of these lenders in Scandinavia, who have access to domestic owned supply, they鈥檙e immediately in demand from the broker-dealer community, because what they鈥檙e bringing to the table is very different from what they鈥檙e currently seeing in supply terms.
Faruki: The next thing you have to look at is the demand. It's great that we can capture all of the supply, but if there isn't enough demand, and there aren't products that need those shares as a borrower, you're not going to have enough to have a fair and balanced market.
While they might look great on the surface, market makers are the worst clients for stock loan, because they take the stock for a day or two, and they return it. From a lender's perspective, where it's a new market, and you're trying to get them active, they don't want to lend their shares out for a day or two, that's not going to generate anything meaningful for them.
Then you have to start looking and ask yourself: who are the kinds of counterparties that would be good borrowers, that would have good utilisation, that would be paying good rates. And then you start looking at long-short and at other strategies that have those kinds of horizons. In the region, there's a huge amount of funds now that are set up with regional bases. They're not just trading globally, they're coming to Saudi, they're coming to other regional markets, and seeing how they can be a part of the capital market activity. That includes initial public offerings (IPOs), stock loan, and even strategies that we don't see elsewhere, like corporate action arbitrage, and merger arbitrage 鈥� we've started seeing demand to borrow that didn't exist two years ago.
Elie Geagea: Indeed demand is picking up. The demand pick-up is driven by new asset managers coming to the region and by the new economic environment. We are in an environment where volatility is observed in the equity market, the equity market is no longer a one-direction market that has been a bullish market over a decade. Volatility is here, so investors and asset managers are looking for hedging solutions. And for hedging solutions, you need an efficient SBL market.
Inflation is here, asset managers are looking more and more for yield pickup solutions and share lending is one of them. You need an efficient SBL market. The low rate era is over. Three or four years ago, asset managers had access to cash in a free and abundant way. It's no longer the case, we are back to a relatively high rate environment. Funding is costly now, so investors are looking for a cheaper and optimised financing solution. This can be achieved through derivative instruments, which can not be implemented without an operational SBL framework. Given the above, the borrow need is picking up, hence the need for diversified and stable supply.
Sarah Alothman: Speaking in general about the growth here in Saudi 鈥� capital markets activities have grown exponentially in the recent five years, and this is due to the changes that are happening in the market. This includes the introduction of the qualified foreign investors, the independent custody model, the listing of the IPOs, post-trade enhancements, the introduction of CCPs and CSDs. This has also helped position the Saudi exchange, or Tadawul, to be the 10th largest global exchange by market capitalisation. This has encouraged strong demand and growth, both from the market and the investor side.
Andrew Geggus: That has a knock-on effect as well. All of those points have then led more investors on the buy side to start taking positions in the market. We hear from all of our borrowers that they're having conversations with their clients about access to the region, and, particularly, access to Saudi Arabia. While we said that we took a leap of faith to try and go live in lending in Saudi Arabia, it was only because we are getting a huge knock on the door from all of our borrowers, and they're getting the same conversation from their clients.
Crowther: We've had to work hard with our clients on understanding the cost of getting into the market to begin with. The build and implement stage versus the run and operate stage, are quite different. There鈥檚 an upfront build integration cost to execute trade number one. There is then an ongoing run cost 鈥� going back to Andrew's point around operations: how do you manage the book? How do you manage the risk? Do you do it out of the global team? Do you have a local team here on the ground? Is there an investment to be made or not?
All of that drives back to the quality of the assets that are available for lending and the utilisation of those. We've worked with a number of clients to look at their business cases and quite a lot of the work that we do at the start of any engagement with a client, is understanding what their operating model is going to be, how they're going to service things, and helping them to cost out what that would look like technology wise.
What are the dangers here? What does this community need to be aware of to make sure that this journey into the Middle East continues as a success story?
Arlando: Firms need to make sure that whatever regulations we鈥檙e putting in place and whatever product design we鈥檙e putting in place is consistent, and essentially leads to efficiency in the market. That efficiency in the market is key, because borrowers are more likely to pay up when it鈥檚 more efficient to them. So globally, whichever market you鈥檙e looking at, if there鈥檚 no borrow demand, there鈥檚 no market.
The one thing that borrowers are really interested in is analytics and data around their trades, trading activity, and their counterparties. They are more likely to trade and engage with counterparties that are efficient to them, because they鈥檙e under cost constraints as well. It鈥檚 important to ensure that, yes, we鈥檙e growing this market, but when we鈥檙e looking at how to grow it and taking it to the next step and beyond 鈥� which we all agree is going to happen here 鈥� that point of efficiency and doing things with best practice in mind, is important.
What is the outlook for the region? Is Saudi full steam ahead and will the other Middle Eastern markets follow? Are we looking at a future pan-GCC market?
Faruki: Market standardisation is a key point. If you look at agreements, operating models, and even cutoffs for required values (RQVs) 鈥� these are all critical things. We joined the International 色花堂Lending Association (ISLA) a couple years ago to learn more about securities finance and how it works globally. We took a lot of positive feedback from the global participants and tried to say: there's clearly market standards and practices that they're willing to share with us and to help us learn and develop our own capabilities in our own market. We have to take the same approach now for market participants, we have to be willing to share information, to share ideas on how we do things, and to try to come to a common standard and practice.
At the end of the day, if I have my own ecosystem, and another custodian has theirs, and the international banks have a third one, it's going to be very hard to do things between different custodians or counterparties. It's not going to allow the market to be efficient. There will be different pricing, depending on how you're documented, depending on how you're set up. Market standardisation is the key thing, and we have to put our own business interests aside and ask: how do we do this in a way that benefits everybody and grows the market?
Geagea: Before covering the SBL outlook part, I would like to go back to the starting point. In 2013-14, there was a will from several countries in the region to increase liquidity and bring foreign investments into GCC markets. Many GCC countries started discussing and preparing for index inclusion. In 2018-19, many GCC countries were included to the emerging and global indices. The index inclusion brought foreign investments and increased liquidity on the secondary market. On the primary side, IPOs in the region were very active and increased local and foreign interest in investing into GCC markets. So in terms of cash equity, work has been done on both the secondary and the primary side.
With increased liquidity and higher foreign investments, there was a growing need to build an efficient capital market. Once you bring liquidity and capacity, the second step is to build efficiency. For an efficient capital market, you need to have three pillars, which are: liquidity, an operational derivative market, and an operational SBL market. For any capital market growth plan, whether in Saudi or other GCC countries, to have an efficient capital market, you need those three pillars
HSBC, as a well-established multinational bank in the region, has started working on those pillars since the early beginning and we are fully confident that the growth story will continue, but growth needs to be done in a smooth and responsible way.
Stephen: Given the potential, across various sectors, of the GCC, I think it would be unwise to bet against the region. In the realm of securities finance and lending, it is crucial for market practitioners, global custodians, and agent lenders, to focus on developing market depth. There's a risk that we assume Saudi is done, move onto the likes of the UAE, Qatar, and Kuwait, and spread ourselves too thin.
Instead, we should double-down on Saudi, for example, and analyse all the different opportunities and the different mechanisms and services that we can put in place to help our clients. As we build up the lending side, we want to build out the ability to take Saudi domestic equities, for example, as collateral.
Foreign banks will face limitations in their business activities if they cannot reuse their assets 鈥� it is our responsibility to develop solutions that complete the system in Saudi Arabia, before progressing to the other markets. While it is, of course, important to stay informed on the developments in other GCC countries, the priority should first and foremost be Saudi Arabia.
Crowther: On the banking side, it makes perfect sense, because you want to make sure you've got something solid, a foundation for that business going forward. Because of the nature of all of the other countries trying to keep pace or catch up, from a technology perspective, we will have to service all of the regions, no matter where they are in their securities finance journey.
The key success is interoperability. Andrew has mentioned it a couple of times and it's spot on 鈥� whether that's at the pre-trade level or at the data vendor level, or even the CSD level, providing all of those capabilities is key to the evolution. If firms successfully bring on more clients, if they can't do them at volume because of constraints around technology, the whole thing falls apart.
So as a service provider, we need to be thinking ahead to not just next week's revenue, but one year, two years, and three years ahead to make sure all of those things are available, and then the market will be a bit more fluid.
Alothman: Saudi Arabia has done more work and input effort into the region. And, eventually, there have been more inflows into the market. The exchange is also catching up with the global market capitalisation. I'm optimistic, so I would say that there is more exponential growth within the next five years in respect to SBL. As Elie mentioned, liquidity is a key. This has been ticked and has been picking up also in the market.
There is an opportunity, there is growth coming, and there have been so many tremendous changes in the market from the inclusion of MSCI back in June 2018 to look at where we are today, qualified foreign investors holding is US$88 billion as of August 2024. Introducing new products to the market will attract more investors, and so we will see more demand in the market.
In regard to the coexistence between conventional and Islamic finance, where are we today?
Geagea: A big percentage of assets, if not the biggest, is held by Islamic financial institutions. If we look at fixed income repo, the Islamic offering has massively picked up in the recent three years. I don't see that SBL will be an exception. As for any OTC transaction, an Islamic SBL agreement needs to be done between two counterparties, and any Sharia discussion needs to be validated by the two counterparties separately.
The key element in the Islamic framework is standardisation. In the Islamic OTC derivatives world, we witnessed a shift toward centralised Islamic guidance and practices of the operation model of any Islamic OTC transaction. Islamic documentations and negotiation refers to the Tahawwut Master Agreement (TMA), a well-known reference and acknowledged across the region. We definitely need something similar in the Islamic SBL world. Standardisation is even a request from international organisations like the ISLA. ISLA is encouraging stakeholders in the Middle East to have a common Islamic regulation and practices, which can be acknowledged by local participants.
Faruki: From what we see right now in supply and demand, it's maybe not important from a borrower side, where lots of the borrowers are international. But from the supply side it's critical that this gets developed, because the majority of clients that we deal with are looking at transacting in a Sharia compliant manner. We've gotten clear feedback that there's ways to do that. But it's just getting the standard documentation, the standard terms, standard way that those trades are processed, to make sure that they are complying with those rules and with that guidance.
Geggus: It's a consideration that we have to take on board when we're reviewing the opportunity of the region as a whole. This is a big element of transacting within the region. The work ISLA is doing is fantastic, and trade bodies like that can really help the market to get a consensus view into certain items in the region. Hopefully we will get some sort of standardisation around that point.
Crowther: From my perspective, over the last couple of years, we've worked with a client in Saudi to extend the capability of the platform to allow them to trade on a Sunday 鈥� which was new for us. Likewise, Bursa Malaysia put in place a strong template around how Islamic securities finance will work for them, which drove system changes and increased system capabilities to match. Any other regulation or standardisation that comes in, in any place, you follow that same suit.
Faruki: It goes back to the question of, is there one way of doing securities lending that works for every single client and every counterparty? And I think the answer is no. You're going to have these different pockets of liquidity and supply. The challenge now is that it's such a new market, we still can't identify what those will look like and what they will be. Just as we're saying clients in Saudi or other markets in the region are interested in lending securities, I'm sure there's maybe not as many, but there's a good deal of clients that are also interested in borrowing securities, and taking certain positions that they weren't able to take previously.
These are all parts of the market developing, and you'll have those different pockets of maybe Sharia compliant only, and ones that face international borrowers. There's also a lot of other points that will come up, like withholding tax, dividend treatment, voting, ect. All are going to create different models and different approaches, but as long as you have some agreement and standardisation, that's what will help to mitigate those risks disrupting the market.
Crowther: That's absolutely no different from any region鈥檚 client requirements. Whether it's a UK-based organisation, or a scandic organisation, they've all got their own rules and regulations. Islamic securities finance is just another client set that we all have to deal with.
Geggus: It comes back to the responsible growth point that was made earlier 鈥� we want this to grow, we want it to be a success, but it has to be done in a responsible way that takes into account the views of the regulators and the trade bodies, and that we work as a collaborative to grow this economy and build the market, rather than try and go alone and and cause issues. So it's all about responsible growth.
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