For those of us old enough to remember, owning shares in a Middle Eastern public shareholding company meant having a piece of paper, a share certificate, stating the company’s name, the shareholder’s name, and the number of shares owned. The share certificate was usually issued by the company, which maintained a shareholders’ registry to document who owned what of its shares. The safekeeping of share certificates was primarily done by investors themselves – the papers were deposited in old fashioned iron and steel safes, or under mattresses.
Middle East capital markets came a long way since then. Many markets in the region now require all public shareholding companies be listed on stock markets. Ownership of shares is no longer proofed via nice, glossy cardboard certificates – dematerialization came to town.
Citing a scholarly work by Rachel Muigai in 2018 on the concrete industry, ScienceDirect defines dematerialization as “…the reduction of the quantities of materials needed to serve an economic function, […].”
For capital markets, dematerialization meant moving from physical, paper certificates of share ownership to electronically recording such ownership. This electronic registration of share ownership is meant to be more secure, and more accommodating to the speed of trading that takes place on stock markets everywhere.
In our dematerialized world, ownerships of shares in listed companies are shown as “statements of accounts” similar to one’s bank statement which shows one’s cash held at a bank. The investor, or shareholder, is issued a statement indicating the names of listed companies she or he owns shares in, and how many shares are owned in each company. The question that arises is: who is authorized to issue such a legally binding ownership statement?
And this is where Central Securities Depositories, or CSDs, come in. CSDs are legally empowered to register ownership of shares of listed companies, and reflect changes in such ownerships resulting from the buying and selling (trading) of shares that takes place on stock markets. CSDs also issue official statements of share ownerships.
One of the implications of the fact that shares are no longer physical pieces of paper but are electronic records of ownership is that shareholders, or owners of shares, can no longer deposit (keep) the shares they own in iron and steel safes or under mattresses to safekeep this form of wealth (as they may do with cash).
Shareholders, be they individual retail investors, or investment funds, have three options as to where they can safe keep the now dematerialized shares they own in listed companies. And the choice between these three locations depends on investor needs, and risk appetites.
It is a reasonable assumption, since the local CSD is where share ownership is legally documented, to keep one’s shares deposited for safekeeping there. As a matter of fact, this is the default setting, so to speak, in many Middle East capital markets.
The shareholder can also choose to keep their shares with their broker. This second option is appealing to some investors who are active traders. Keeping the shares with their broker means that investors can execute sell orders faster than having to transfer the shares from the local CSD to the local broker before selling. Transferring shares from the CSD to the broker can take 24 hours and this waiting time may cause a loss of an attractive sell opportunity.
The third option is to keep one’s shares with a custody service provider.
Custody is the service of safekeeping shares, and other securities, on behalf of investors. Custody is a service typically offered by banks. And it is not difficult to see the connection here – when share ownership was manifested in physical paper certificates, investors who did not have iron and steel safes used the safe vaults of banks to safekeep these “certificates of value.”
Overtime, as shares got dematerialized, the custody service provided by banks was no longer related to the safekeeping of physical share certificates but the electronic safekeeping of the the dematerialized shares themselves – as a bank client electronically transfers money to their bank for deposit in their account, they can also transfer and deposit their dematerialized shares with their bank for safekeeping.
The custody service offered by local banks is important to international investment funds investing in frontier and emerging markets, such as those of the Middle East. These funds have fiduciary responsibility towards the pension funds and family offices who give them monies to invest.
Investopedia provides a good summary of what fiduciary responsibility is all about: fiduciary responsibility “…involves actions taken in the best interests of another person or entity.” “The fiduciary accepts legal responsibility for duties of care, loyalty, good faith, confidentiality, and more when serving the best interests of a beneficiary.” “A breach of fiduciary duty occurs when a fiduciary fails to act responsibly in the best interests of a client.”
Duty of prudence is part of fiduciary responsibility. “Fiduciaries must administer matters and make decisions concerning the interests of beneficiaries with the highest degree of professional skill, caution, and critical awareness of risk.” A breach of fiduciary responsibility can lead to legal action in courts of law that put penalties on those who breach and award all sorts damages to those that suffer a breach of fiduciary responsibility. Loss of reputation to those who breach is also major blow.
International investment funds trading the region typically have two main relationships: one with a prime broker, and the other with a global custodian.
The prime broker is there to execute buy and sell orders for the fund, buying and selling listed shares, as per the decision of the fund management. The prime broker also at times provides research on listed companies as well as margin financing to the fund. The prime broker may be able to execute directly on a local exchange, if it is licensed locally to do so, or it can use the services of a local broker to serve its investment fund clients.
The global custodian, typically an international bank, chooses a local custodian bank to serve the custody needs of its clients, the investment funds. The local custodian bank safekeeps the shares owned by the investment fund, and acts as part of a checks and balances system that the fund puts in place to fulfill its fiduciary responsibility towards the pension funds and others that give the fund monies to manage and invest on their behalf.
Unless the fund is actively trading certain shares, it will not keep shares with the local broker, for reasons of fiduciary responsibility. The broker may go bankrupt, or fraud may be committed at the local brokerage house. Investment funds need to guard against such scenarios and usually do this by keeping the shares they own at the local custodian bank.
Investment funds can certainly choose to keep shares they own at the local CSD, but most do not opt for this option, even though Middle East CSDs are primarily owned by local governments, either directly or indirectly. This is because investment funds require additional services when investing in frontier and emerging markets, services that Middle East CSDs are not fully able to offer yet.
In addition to the safekeeping of shares (custody), international investment funds require services such as the collection and remitting of company dividends (the profits that listed companies distribute at the end of each year to shareholders) and interest payments on debt instruments (such as those paid to the holders of government or corporate bonds). Implementing company corporate actions, such as the distribution of free shares to existing shareholders, a common practice in the region, is also a service that international investment funds need someone on the ground to undertake on their behalf. Voting at shareholders’ meetings by proxy is another service in increasing demand that local custodian banks can do for international investment funds.
By and large, CSDs in the Middle East are not yet fully able to offer international investment funds the complete suite of these corporate action services. To their credit, some CSDs in the region have started on the dividend distribution service offering but, from an international investor’s perspective, it makes more sense to have all the needed services offered by one service provider – a local custodian bank that is vouched for by the investor’s global custodian.
The custody service industry in the Middle East has ample room for growth. On the supply side, some countries have both global and local custodians offering custody services to international, regional, and local investors. On the demand side, clients of custody services in most Middle East markets tend to be international investment funds. Growth of custody service provision is increasing as more local banks start offering this service. Growth of demand for this service is increasing as more local retail and institutional investors start seeing the added value of using the services of local custodians. Regulatory changes that would require all investors, local or international, to have custody accounts, be they at the local CSD or with a local custodian, will also increase demand for custody services in the region.
It is not easy for a local bank in the Middle East to equip itself with the infrastructure needed to offer custody services to global custodians. Investments in technology in addition to, more importantly, personnel are needed to offer custody services according to international best practices and in manners that enable the underlying investors, the international investment funds, fulfill their fiduciary responsibilities.
For global custodians to board local custodians, a long due diligence process is involved. And the relationship, once established, is only revisited once every three years or so – unless there are compelling reasons to do.
The relationship that an international investment fund has with a local custodian is different from the one it has with a local broker. The latter is more short term - the risk element is basically based on a trading cycle of T+2 and as a result buy and sell orders can be executed with a local broker of choice, monitored by the fund’s local custodian.
Choosing a local custodian, on the other hand, is normally the decision of the global custodian bank serving the investment fund – not of the investment fund itself. This is all part of fiduciary responsibility issues.
Custody service fees in the region fall under what banks call off-balance sheet revenue streams – these are revenue generated without lending and, as such, this type of service provision does not normally impact banks’ capital adequacy ratios. Off balance sheet revenues actually increase a bank’s return on equity – a bone of contention between shareholders of some banks in the Middle East and the management of those banks.
If your bank is returning around 10 on equity and other banks in the region or internationally enjoy ROEs of 20 or more, then, as a bank CEO, you may wish to consider increasing your off-balance sheet revenues by offering new services to new and existing clients – custody is certainly one of those services you should consider.
The business model of universal banking has been undergoing revision since before Covid. As international banks continue to resize their global presence, local and regional banks in the Middle East are enjoying new room to expand service offerings to local and international investors, and custody services are ripe for the picking.