Despite the region being rich in natural resources, it was not immune to the global financial crisis. Colin Packham investigates the development of the Middle East futures and options market, examining the impact of the global recession, the proposed enhanced exchange landscape, and the prospects for the region.

The Middle East is one of the world economy’s most impressive success stories. The Gulf Emirates have built world-leading infrastructure in only a few decades. The region’s economic success relies both on internal strengths and its international openness, and some experts say that it will be the same for its derivatives markets.

The market in the region is dominated by bourses in Dubai. While the Middle East’s appetite for commodity trading led to the creation of two commodity derivatives exchanges, the region was already home to a number of stock exchanges but equity derivatives were yet to be offered. That changed when Nasdaq Dubai – formerly called the Dubai International Financial Exchange – introduced its equity derivatives platform in November 2008 and with it a series of equity derivatives linked to a number of high profile stocks in the Middle East region.

While Dubai has led the development of derivatives in the Middle East, other nations are beginning to catch up. The Bahrain Financial Exchange is the latest exchange to go live, having launched in October – while several other regional bourses are also lining up new futures and options.

Reliable growth

The growth of the Middle East derivatives market has been steady and was not interrupted by the financial crisis, though it may have been slowed.

The Dubai Gold and Commodities Exchange, the oldest derivatives market in the region, is the largest by trading volume. Activity has grown steadily every year since the exchange opened in 2005, and by the end of October 2010 DGCX had racked up 1.55m contracts traded, more than in all of 2009. The leading products are futures on gold and the dollar exchange rates with euros, sterling and the Indian rupee. The exchange’s West Texas Intermediate Crude Oil Futures have traded 100,000 times in those 10 months. Each of the cash-settled contracts represents 1,000 barrels of oil.

The four year old Dubai Mercantile Exchange, too, is growing robustly - its 607,000 contracts in January-October 2010, all of them 1,000 barrel physically settled Oman Crude Oil Futures, comfortably exceed the 553,000 contracts exchanged in all of 2009. DME's only other product is a financially settled version of the same contract, which has not traded since 2008.

Trading at Nasdaq Dubai only began in January 2010, and is still in its infancy. About 37,000 stock futures have been traded so far, with about 6,000 trades in each of September, October and November.

Local strength in the teeth of recession

Despite the region’s seemingly invulnerable economy – given its position as global leader in oil – even the UAE found itself hit by the world recession. This was particularly true of Dubai, which had invested heavily in property, an asset class which suffered disproportionally when the building boom unravelled.

However, despite the downturn in the region’s fortunes, the Middle Eastern exchange-traded derivatives market remained strong and buoyant.  

Why was it so resilient? Well, as Paul Eid, head of Newedge Dubai says, it owes much to local players shifting demand away from the international powerhouses, like the CME Group, Eurex and Liffe – and moving to local markets instead.

“In 2007, just before the crisis, the local institutions were actively trading on the major markets like the CME Group, Eurex, Liffe. The effect of the financial crisis was immediate. Driven by a desire to protect the region’s banking sector, the firms stopped their activities on the international derivatives markets,” Eid says.

The head of Newedge Dubai says that while the funds and banks have continued to invest internationally, these trading firms have switched to asset classes with less leverage such as bonds, and have also traded greater volumes on the local exchanges.

Demand for clearing

Eric Hasham, interim chief executive officer of the Dubai Gold and Commodities Exchange, says counterparty concerns have also driven demand back into the region. He says DGCX may have benefited more than any other local exchange because it is the only regional exchange to offer its own clearing house, so any trading firm with concerns regarding their capital was keen for the money to remain within the UAE.

“We have had a lot of interest in being able to offer counterparty risk removal, that’s been a big selling point since 2008,” Hasham says. “We benefited a lot with the concerns from many here in the region as to counterparty risk.”

While domestic trading has propelled the region’s exchanges to continued growth, international participation remains steady. Hasham says that approximately 20% of the DGCX’s trading volume comes from the US, Europe and Asia, but there is continued interest from outside the UAE in doing more business. For example, DGCX’s Indian Rupee-Dollar Futures are the only such instrument outside India, and foreign residents cannot trade FX derivatives in India.

Perhaps best positioned to achieve greater international participation is the DME, which has as a partner the largest global exchange, the CME Group, and lists its products on the US bourse’s electronic platform CME Globex – accessed by a significant proportion of global traders.

“The strength that the CME Group brings is phenomenal,” says Thomas Leaver, CEO of the DME. “They have the largest electronic trading platform in the world, arguably the most sophisticated, the largest distribution system, and a huge organisational system. In their own words, they see the DME as the ‘jewel in the crown from the Nymex acquisition’,” Leaver says of the benefits of having the CME Group as a core partner and shareholder in developing the exchange.

Product launch deliberations

As volumes grow at each of the region’s derivatives exchanges, the bourses are determined to make use of the momentum. However, each insists that unlike some of their global competitors, any new product will be offered after careful consideration, with strong demand from their members for the products, and with the full support of their regulators.

Leaver says the DME is in no rush to launch new products, but is concentrating on the soon-to-be launched six DME Oman-linked swap and option contracts on the CME Group’s OTC clearing platform ClearPort.

Leaver explains why market participants asked the DME to have ClearPort list the OTC contracts: “The Dubai swap market is probably the largest swap market east of Suez. It has grown out of having Dubai as the only transparent pricing benchmark for physical barrels east of Suez. But because of a decline in production over the years, it is no longer an accurate or effective reference for real oil prices. Consequently, Brent-Dubai spreads developed to manage east of Suez price risk. However, this form of trade is not the perfect hedge as there is a significant basis risk with the east of Suez market vs. the North Sea.”

DGCX is also working on new products. Its latest initiative is an agreement with the index provider Dow Jones to list a suite of equity index products, beginning with the Dow Jones Islamic Market Titans 100 Index, although Hasham says this is still subject to the approval of its regulator.

Hasham says there is plenty of scope for continued growth at the DGCX through both product expansion and encouraging regional players to use hedging instruments – and perhaps even through a move many of its global rivals are pressing to offer. Central counterparty clearing is now the buzzword of many global regulators – and exchanges quick to realise how the land lies have sought to offer OTC clearing.

The DGCX is well placed to be able to introduce such a service for the MENA region and Hasham reveals that the bourse is “monitoring” what is being undertaken elsewhere and that this could be something that happens down the line. However, while accepting it’s a possibility, Hasham says he sees more immediate developments in the exchange’s product suite.

While the Dubai exchanges are working hard to grow trading volumes, several new Gulf rivals are also working to develop derivatives offerings. The Bahrain Financial Exchange, which launched only in October, is working on developing its suite of futures and options, having signed deals with index providers FTSE and Dow Jones to list equity index derivatives covering the Middle East, India and Europe.

The Qatar Exchange, partly owned by NYSE Euronext, is also developing a suite of derivatives. In early September, it upgraded its technology to NYSE Euronext Universal Trading Platform, and according to Andre Went, CEO of the Qatar Exchange, derivatives will follow, but a timeline has yet to be finalised.

Foreign investment will boost domestic investment

The fortunes of the regional exchanges will, of course, depend on the success of the products offered. With so many players in the market, every exchange is eager for a unique selling point by positioning themselves in a niche and owning it.

With the DME, according to one London-based oil trader, the breakthrough will depend on acceptance of the Oman Crude Futures pricing as a benchmark. The Dubai Government uses the Oman pricing but the London-based former exchange executive says the benchmark must be used extensively within the region before traders will begin to migrate away from the traditional WTI and Brent benchmarks.

For the DGCX, Nasdaq Dubai, BFX the route to success may be slightly simpler: grow trading members, encourage greater participation from existing firms and add new, well constructed products.

With a plethora of exchanges either live or set to go live in the Middle East, how can each be successful? Perhaps surprisingly, according to Eid, the market must hope the domestic trading firms, particularly the funds that invest substantial sums, do so overseas.

The Newedge executive says he believes the Middle East investors will move back to heavyweight exchanges sooner rather than later to diversify and hedge on liquidity-rich markets, but this will also help the local exchanges, encouraging in turn greater international trading – creating a win-win situation.

Eid is sanguine about the prospects of the UAE derivatives market, concluding: “I’m bullish on the Middle East listed derivatives market five years ahead. The local investors will have to come back to the international exchanges and this will be a key driver for the local exchanges.”