Posted on 14 March 2012.
At the end of last month the Egyptian investment bank EFG-Hermes announced that it would begin offering equity swaps on ISX-listed shares to institutional investors. (See this story.) This new product has the potential to bring about a dramatic increase in foreign participation in the Iraqi stock market.
An equity swap allows an investor to earn the return on the underlying name without actually owning any shares. The issuer of the swap mimics the performance of the stock by doing trades in its own account that parallel clients’ buy and sell orders while simultaneously debiting or crediting their cash accounts by the corresponding settlement amounts.
Swaps have three main advantages. First, they replace local counterparty risk with that of the issuer. Second, they eliminate the need for a custodian bank. Third, they can greatly simplify the investor’s back office and audit work.
In a market like Iraq, these are all important considerations. Many foreign institutions will be unwilling to accept the risk of dealing directly with Iraqi brokers. So far no one is offering custody services for ISX-listed shares, which means that many funds cannot invest at all. (See this post for more on custodian banks.) And even when the Iraq Securities Commission finally gets around to issuing custodian banking licenses many investors are still going to find dealing with EFG-Hermes to be a lot less trouble administratively.
In fact, even in markets like the UAE, Qatar, and Kuwait—all of which have custodian banks—many foreign investors continue to prefer swaps solely for the sake of ease of settlement and execution.
The lack of a custodian for ISX-listed shares is suddenly starting to look like a red herring. Institutions no longer need to wait for this problem to be sorted out. Now they can start trading in the time it takes their own legal and compliance departments to review the EFG-Hermes swap agreement. (This is a non-ISDA document so this process may take a bit longer than it otherwise would.) Some may be ready to take the new shortcut to Iraq as early as the end of this month.
Dr. Mark A. DeWeaver
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