The region's nascent forex sector has enjoyed massive growth in recent years, but obstacles – such as the current liquidity crunch – remain.
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The Middle East's foreign exchange industry has evolved rapidly over the past few years. Starting from a rather negligible base, the sector has thrived thanks to a low-yield environment and growing investor appetite.
According to figures from the Bank for International Settlements (BIS), trading in forex averaged $5.3 trillion per day in April 2013, with the Middle East's retail currency market accounting for 8 per cent of the global amount.
It is a significant share given the region was a late adopter of forex as an asset class. The industry was still in its infancy just a decade ago, with investors looking primarily to real estate and equities to hedge deal transactions.
With the rise of the regional equity markets, which served as the foundation for alternative investment products in the Gulf Cooperation Council (GCC) region, interest in forex began to take hold. But it was only after the 2008 global financial crisis that investors recognised that forex provided better returns than other asset classes.
"The number of users of FXGO, our electronic trading platform for FX, increased by 30 per cent in the Middle East in 2015," says Tod Van Name, global head of FX and commodities electronic trading at Bloomberg. "By comparison, our global user base increased by 16 per cent year on year to over 10,000 users. We have also seen high double-digit growth in volumes in the Middle East, with an 80 per cent increase in the number of trades over the past two years."
Strategic growth
While forex inflows and outflows did not account for much five years ago, today, traders across the GCC trade the same products as their counterparts in London or New York. The sector has experienced trade volume growth of more than 50 per cent year on year since 2011.
"The Middle East's importance is rapidly growing in the global forex market, especially with its retail segment, compared to a relative slowdown and decline in other global markets," says Anthony Hobeika, chief executive officer at MENA Research Partners.
This growth is largely driven by increased investor awareness of the opportunities available in forex as well as the region's strategic location between Asia and Europe. The local time zone enables it to capture market opening hours in the Far East as well as US closing hours in the same working day, giving it better access to the wider global market, particularly the G7 currencies.
"The GCC is a major corridor for global FX flows and we have seen an ever-increasing number of players in the market, as well as consistent growth in the number of people transacting in FX," says Gifford Nakajima, head of wealth development for Middle East and North Africa at HSBC.
Dubai essentially led the way in establishing a burgeoning forex market, investing in the necessary infrastructure and creating a financial sector that has come to serve as a regional hub for many international institutions. The creation of the Dubai Gold and Commodities Exchange (DGCX) helped cement the emirate as the regional centre for financial trade and has attracted many international investors and firms.
"Given the strong growth of the UAE economy and the increasing number of expats coming to live and work here, we have seen FX transactional flows rising, both in and out of the country," says Nakajima. "Even in terms of the broader region, Saudi Arabia and the UAE are among the top three remittance markets globally."
DGCX is now the biggest pool of the Indian rupees (INR) offshore futures market, with the value of the INR traded on the exchange exceeding $1.5 billion per day in 2015.
Compared to other markets, the region's low-yield environment combined with low risk appetite has attracted more investors towards forex, mainly safe-haven currencies such as JPY and XAU (gold). The most popular currency pairings in the region are EURUSD, GBPUSD, XAUUSD, EURJPY and XAGUSD.
Liquidity concerns
However, the region is currently facing a liquidity crunch. With economies heavily dependent on oil, the volatile price over the past 18 months has affected both the equity markets and the local banking sector, which are now allocating risks to asset classes away from forex.
The geopolitical situation in the Middle East is causing a great deal of uncertainty, as are issues in the Eurozone and the possibility of a Brexit, which are impacting both the Euro and British sterling. Last year, the Swiss National Bank's decision to stop supporting the Swiss Franc sent shockwaves around global forex markets, including the Middle East.
The failure of the participants of the Doha Accord to reach an agreement on capping oil production has led to further drops in the price per barrel and will increase pressure on the regional forex pegs. But besides the volatility in oil prices, the lack of new deposits in local banks and enforcement of US regulations to prevent tax avoidance and money laundering have fed into the liquidity crunch, limiting access to USD in the local currency markets.
Moreover, US banks have declined business with foreign institutions to prevent these extra costs, which prompted the central bank governors of the UAE and Bahrain to publicly state that it has become more difficult for some local banks to conduct US dollar transactions.
Saudi Arabia and Kuwait's move to stifle speculation against the riyal and dinar respectively in the forwards market also fed into the liquidity issues. In January, Saudi's central bank urged banks to avoid conducting derivatives trades that would pressure the riyal. Then in February, Kuwait's central bank stepped in to manage movements in its daily dinar fixing to deter speculation. These measures led to a dip in forex trading activities as speculation fell and foreign banks began to supply fewer dollars.
Call to depeg
Such pressures have led to calls to depeg local currencies from the dollar. Currently all GCC countries except Kuwait have their currencies pegged to the dollar. The peg previously enabled a low-yield environment, which promoted safer investment and encouraged growth of the forex sector.
But the current economic and geopolitical environment has resulted in an instability that threatens the peg's future.
"With many oil-rich governments drawing on their foreign reserves, defending the currency pegs could become – although a long way still lays ahead – at stake more than ever," says Hobeika. "This is creating a number of opportunities of actively trading the regional currencies and furthering the depth of its market."
The peg has enabled the region to keep inflation low, simplify trade and financial transactions, and reduce uncertainty during times of volatility, both politically and economically.
"We think that there are three aspects to consider when evaluating the future path of FX policy in the GCC: willingness, desirability and ability to maintain the USD pegs," says Jean-Michel Saliba, Middle East and North Africa economist at Bank of America Merrill Lynch. "We believe all GCC countries share a willingness and commitment to maintain FX policies."
The USD peg has served the GCC well for decades by "providing a nominal anchor to the economy and expectations," Saliba adds. "The literature suggests the optimal choice of an exchange-rate regime should yield external and international stability, preserve monetary credibility and competitiveness and reduce balance-sheet risks and transaction costs."
So while it is becoming costly to maintain the peg, it is providing a level of stability for the wider economy, while many of the GCC member states have enough foreign assets and reserves to mitigate the pressures of the peg.
Ongoing challenges and opportunities
While growth is still expected, the industry is facing many challenges and there is a need for more market regulation. For now, the lack of liquidity and central bank interference remain the biggest threats.
But there is hope by way of economic diversification. Over the past few years the GCC has invested billions in making their economies less reliant on oil. The UAE – in particular, Dubai – is the most convincing example.
"The fall in oil prices has had an impact, which has been mitigated by the continued growth of other sectors of the economy such as manufacturing, construction and tourism," says HSBC's Nakajima. "The countries receiving remittances from the UAE have benefited from lower oil prices and the corresponding strength of the US dollar has resulted in an increase in real estate investments abroad as well."
Investment in technology and electronic forex platforms also provide local investors access to both international and regional liquidity, moving away from local banks that have come up against deposit outflows.
Just as equity markets have developed a range of linked investment vehicles, the same, it seems, is happening in forex, as interest grows and new products are bound for the region.
Another growth area is in Sharia-compliant forex trading, amplified by the increased availability of Islamic trading products.
"For example, swap-free accounts are considered Sharia-compliant, giving access to forex trading without compromising Islamic principles," says Hobeika.
Demand for Sharia-compliant products comes mostly from the retail sector. But it is still in its infancy when compared to Islamic banking and may take many more years before it can compete with conventional forex in the region.
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