Caught short

Will the DIFX's launch of derivative trading this year risk unwelcome exposure to short-selling?
Caught short
By Andrew White
Sun 28 Sep 2008 04:00 AM

The Dubai International Financial Exchange will become the first Gulf bourse to launch derivatives trading later this year. Yet with the global markets in turmoil and Gulf indices fluctuating wildly, is there a risk of unwelcome exposure to short-selling? Andrew White reports.

In early july, the Dubai International Financial Exchange (DIFX) stole a march on its rivals as it announced it would become the first exchange in the region to offer futures and options based on stocks listed on the bourse.

The move was hailed as indicative of the exchange's growing sophistication and heightened profile on the international markets stage. If New York, London and Tokyo boast derivatives trading, then so must Dubai.

For investors participating in derivatives, there’s much more risk attached to them.

However, three months later and the global markets are witnessing a backlash against the practice of short-selling, where traders aim to profit from falling prices by borrowing shares and selling them in the hope of buying them back for less. Critics claim that the practice has pushed down global markets - and could do the same in the Gulf.

Derivatives such as futures and options are contracts whose value is linked to the price of something else. Some investors buy or sell them to guard against changes in the value of securities they already own. Others use them as a hedge against volatility.

The DIFX is pushing ahead with its plans and CEO Jeffrey Singer tells Arabian Business that the exchange will go through with a soft launch before the end of November. Moreover, he confirms that short-selling is - and will be - permitted by the Dubai Financial Services Authority (DFSA) and DIFX.

"We received regulatory approval in July, signed our market maker shortly thereafter, and now we're setting up the trading members," he says. "Our next step will be to set up the products and make them available to the market, and we're very close to having this completed."

While the DIFX pushes ahead with its plans to introduce derivatives trading before the end of the year, others are warning against the dangers of further exposing the struggling market to the dangers of short-selling.

"We cannot blame any party specifically, and not the brokers indeed, who only execute the orders without necessarily being aware whether it is for redemption or short-selling," Essa Kazim, chairman of Dubai Financial Market (DFM) said last week. "However, this practice needs to be stopped as it inflicts serious damage to our markets."

Back in 2002, billionaire investor Warren Buffett described derivatives as "financial weapons of mass destruction" - and six years on, market regulators around the world are doing their best to shelter themselves from the blast.

"[Short-selling] can be used by market participants to create artificial situations out of which to make abnormal profits," says Zahed Chowdhury, head of Middle East research at Deutsche Bank AG. "And of course, to allow derivatives trading without having the proper rules and regulations in place would be a big problem."

According to the Bank for International Settlements, the global over-the-counter derivatives market increased 15 percent to $596 trillion in the second half of 2007, while the equity derivatives market shrank 1 percent to $8.5 trillion. Yet the backlash has begun in the aftermath of one of the most cataclysmic periods in recent financial history.

When US financial giant Lehman Brothers filed for bankruptcy protection on September 15, it triggered a global collapse of markets already spooked by the rushed $50bn sale of Merrill Lynch to Bank of America.

Wall Street titans Goldman Sachs and Morgan Stanley abandoned the investment bank model 75 years after Congress separated them from deposit-taking lenders, and the world's biggest insurance company, AIG, had to be resuscitated by an $85bn injection from the US government.

By the end of the week, Wall Street was on its knees, while the S&P 500 suffered its steepest plunge since the 9/11 terrorist attacks.

And while the high oil price has ensured the Gulf markets have to a large extent been insulated against the worst of the global credit crunch, Gulf stocks have spent the last fortnight in a state of chaos. So far this year, stocks on the Saudi Tadawul - the region's biggest bourse - have declined by over a third.

Meanwhile, the UAE Central Bank said it is to pump $13.6bn into the banking sector to prevent the credit crunch that has hit global markets spreading to the Gulf state. It did not give details on how the facility would be structured or operated.

To help calm plunging financial markets, the US Securities and Exchange Commission issued a temporary ban on selling 799 financial stocks short - a practice that has been blamed for forcing down the share prices of investment banks such as Goldman Sachs and Morgan Stanley.

In the UK, the Financial Services Authority has a moratorium on short-selling 29 leading financial stocks, while Australia has completely banned short-selling.

Germany, Ireland, Switzerland and Canada have banned short-selling leading financial stocks, and France, The Netherlands and Belgium have banned ‘naked' short-selling - the practice of selling a stock short without first borrowing the shares or ensuring that the shares can be borrowed.At the DIFX, Singer argues that the emergency steps taken by those regulators are aimed at stopping the ‘buy' side from creating a downward spiralling effect in the financial sector. The DIFX has business rules in place that prohibit ‘naked' short-selling, but the DFSA does not prohibit or restrict covered short-selling.

"These steps are not aimed at the market makers and those who short stock as the normal part of creating a liquid market," he explains. "The DIFX is an international market and we're regulated by the DFSA. We have no financial institutions listed on our market - our companies are not being targeted by short-sellers."

Elsewhere in the emirate, investors have been strongly cautioned against short-selling by the DFM. In a statement issued last week it said that short-selling was not in keeping with the spirit of its regulations, and urged "all parties to abide with established regulator rules and refrain from practices which are not yet codified in local markets".

"The big problem right now is that you have big synthetic shorts being offered by the international banks that are not regulated by the local authorities," says Francois Van Rensburg, an asset manager at EFG-Hermes. "There's less transparency on these transactions."

Indeed, the Securities Exchange Authority (SCA) has admitted that it currently has no regulatory powers to curb the practice of short-selling. While DFM rules do prohibit naked short-selling, "In the absence of a legal framework it is difficult to regulate short-selling as it requires some elements such as the implementation of margin trading regulations for a certain period of time," Abdullah Al-Turifi, CEO of the SCA said in a statement.

"What's gone on is an under-regulated level of activity, not just on derivatives, but on a whole series of asset classes," warns Chowdhury at Deutsche Bank. "If you have the rules and the regulations without a proper oversight in regulation of those activities, then you're asking for trouble."

Some analysts argue that in the current climate, the DIFX's derivatives plans should be delayed to appease investors concerned that short-selling will drag Gulf markets even deeper into the mire.

Any shift in the schedule would also allow the bourse's regulators to put firm rules in place to curb the practice.

"Policymakers and regulators will want to deepen their understanding, which would mean the setting up of more committees and more discussions - basically more time to make sure that they've got all sides covered," says Chowdhury. "It may well push the deadline to after this year. There's a lot going on and some fundamental structural shifts not only in the markets, but also in the market participants globally. So I think everything and everyone is in a ‘watch and see' mode right now."

Some even caution that the current economic climate means people could shy away from risky propositions such as derivatives - and so lead to a lack of demand for the trades.

"The success of these things is determined by the investor take-up. For investors participating in derivatives, there's much more risk attached to them - and in the current global environment there's a lot of uncertainty," warns Van Rensburg at EFG-Hermes.

"There is the chance that the demand will not be there, as the current economic circumstances will make people generally more wary of participating," he continues. "Whether the DIFX launch of derivatives is a success or not, it will definitely be impacted by the current uncertain times."

Nor is the backlash confined to derivatives trading alone. In the Gulf, it is also building against the hedge funds which represent the majority of foreign investment into the region. Some are being blamed for exacerbating the markets' downward slide by positioning themselves with shorts, while others have pulled foreign investment out of the Gulf due to the global turmoil.

"From a market point of view it's good to have hedge funds as they provide depth to the market," says Van Rensburg. "But it's a tough time internationally now because of the stuff that has been pushed through naked short-selling - for a lot of hedge funds, this is the business they do globally."

In the Gulf, it is a bitter pill to swallow that the foreign investors who for so long have been demanding access to local bourses, are now fleeing the scene. Last month the Saudi Tadawul - the region's biggest bourse - opened its doors to foreign investors for the first time, entitling them to buy shares through certain intermediaries authorised by the kingdom's Capital Markets Authority. Now, the promised bull-run has turned bearish.

Maha Al Ghunaim, founder of Kuwait-based Global Investment House, notes the "extreme" nervousness of foreign investors when it comes to emerging markets, as they have been rushing to sell at "any price". "The foreign investors are impacting the markets open to them in quite a strong way," she argues. "It is likely that they are, unjustifiably, bringing prices down."

At EFG-Hermes, Van Rensburg agrees that 2008 has been characterised by hedge funds "coming in and going out again". However, he argues that the introduction of derivatives is a required development for the Gulf markets - as long as the demand is there.

"To date the DIFX has been kind of quiet," he says. "With the companies that have listed on the exchange, there has been a lot of demand initially, but then that has dropped subsequently. The DIFX still has quite a bit to prove."

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