32 Trading Minefields | Emerging and Frontier Markets

Emerging and Frontier MarketsAll traders will agree that not all markets are created equal. However, most are only closely familiar with the developed markets like those of France or Germany. Far fewer are familiar with markets of countries with economies that are in early stages of development, such as the emerging and frontier markets.

There is no clear definition of emerging or frontier markets. This is primarily because a country may be classified differently depending on the organization that is doing the

classification. For example, Financial Times Stock Exchange (FTSE) classifies Qatar as frontier, while Morgan Stanley Capital International (MSCI) classifies Qatar as emerging. In another instance, South Korea is classified by FTSE as Developed, and by MSCI it is classified as Emerging. At Convergex, we use the MSCI classification for differentiating markets because the investment community considers MSCI’s indices as the benchmark in non-U.S. markets. So, that is what we will use in this chapter. MSCI classifies markets based on the country’s economic development, size, liquidity, and market accessibility. The lists are reviewed every year and every market has a potential of being reclassified based on that review.

The countries with markets that are classified as emerging are generally experiencing rapid economic growth and expansion. The biggest four emerging markets are: Brazil, Russia, India, and China (commonly referred to as the “BRICs”). The term “emerging” is a bit misleading since being an emerging economy doesn’t mean a country has just began to build up its economy. Rather, emerging is meant to signify the country’s economic emergence onto the global stage. However, what makes them emerging rather than developed is a high level of risk caused by volatility, limited access to liquidity, and political or currency instabilities.

Frontier markets are the least developed of all global markets; these countries generally have weak or unstable economies. They may not have very well regulated stock exchanges or may not even have one at all. Frontiers comprise the riskiest markets in the world because of low regulations, lack of transparency,

and high transaction fees. Participants in these markets are also subject to great political and currency risks.

Given the risks inherent in frontier markets, it is logical to question why a rational investor would want to trade and invest there.

Risk is part of the appeal. As modern portfolio theory suggests, an increased level of risk

BrazilChileChina- ShanghaiChina- ShenzhenColumbiaCzech RepublicEgyptGreeceHungaryIndiaIndonesiaMalaysiaMexicoPeruPhilippinesPolandQatarRussiaSouth AfricaSouth KoreaTaiwanThailandTurkeyUAE (Abu Dhabi)UAE (DFM & DPW)

Frontier Markets Emerging Markets BahrainBangladeshBosniaBotswanaBulgariaCroatiaEstoniaGhanaJordanKenyaKuwaitLatviaLebanonLithuaniaMauritiusMoroccoNigeriaOmanPakistanRomaniaSerbiaSloveniaSri LankaTunisiaVietnamZimbabwe

Trading Minefields | Emerging and Frontier Markets 33

requires increased level of expected returns. Emerging and frontier markets have both, a high-growth potential and a possibility for great returns. Plus, securities from those markets can be a great way to diversify a portfolio.

Still, we would recommend anyone interested in trading in frontier and emerging markets to educate themselves. While the rewards may be high, so are the risks. Emerging markets are often volatile, illiquid, highly fragmented, and largely block driven.

If you are willing to face the risks, the first thing you need to determine is whether you can trade in these markets. Many of the frontier and emerging markets have substantial requirements before a foreign investor can trade in them. The regulators often set rigorous limits on how much a foreign investor can invest in certain companies in order to protect state interests. Part of these restrictions come in the form of investor identification (ID). IDs help markets differentiate between local and foreign investors and allow markets to put limits on foreign investments. Each country has its own set of rules for investor identification.

If a country requires foreign investors to identify themselves, steps must be taken to register with the country’s regulatory body. The investor’s custodian will help with the process. Sometimes an investor may need more than one ID for one country. For example, there are two exchanges in Dubai, the Abu Dhabi and the Dubai Financial Market; an investor needs a separate ID for each of them.

The time it would take to get the ID varies country by country. Some countries have a fairly straight forward and easy process; in others, it is very difficult.

After you get your ID, you have to set up a brokerage account with a local trader. This can also take differing amounts of time based on the country— anywhere from a week to a month. For example, in Taiwan, it’s against the law for foreign brokers to contact Taiwanese investors. Taiwanese local custodians must be the ones to initiate contact. If you try, you will most likely be ignored, as it is illegal for a local broker to respond to you. Similarly, in other markets, such as Nigeria, the client’s custodian must also grant permission to the local broker before any trading can occur. On the other hand, in South Korea you could probably get an ID set-up before the market opens if you suddenly realize you need one to trade a certain stock.

Since limits can sometimes discourage investors from trading in certain countries entirely, some countries take steps to make the process easier. In Thailand for example, there exists the Non-Voting Depository Receipt (NVDR). The NVDR is a trading instrument—a security, issued by the Thai NVDR company, that is automatically regarded as a listed security by the Stock Exchange of Thailand (SET). It was created to attract

Exchange ID Components ID ExampleAbu Dhabi A local custodian number + numbers HSBC000000 DFM Letter of the country +numbers NLD00000000000X

34 Trading Minefields | Emerging and Frontier Markets

more foreign traders to the SET by taking away the foreign ownership restrictions. NVDRs offer the same financial benefits as if they were ordinary shares. The only catch is that NVDR holders are not be allowed to take part in the company decision-making and have no voting rights.

One of the last things to know is that in certain markets, many of which are in the Middle East, you must have the cash or stock ready in advance prior to trading; it’s called thepre-fund. A broker can sometimes have two accounts with their custodian in certain

markets, a custodial account and a trading account. So, in order to execute a trade, either stock or cash has to be moved into the trading account before the trade happens. In India for example, if you are selling and buying on the same day, you cannot fund your purchases with your sales. The way the settlement structure is set up, the proceeds from your sales would not be available for the payment of your buys; you have to have the cash in place before you buy, because the settlement from your sells will not be available.

Also, keep in mind that certain foreign markets keep different trading hours and even days. While you may have considered differences in time zones, make sure that you are aware on what days the markets are open. In some Middle Eastern countries, such Qatar and Dubai, markets trade from Sunday to Thursday. See the Mini-Minefields section on pages 71-3 of the Traders’ Guide to review which countries have lunch breaks, which keep to

Daylights Saving Times and which don’t. To see which hours different markets trade and on what holidays they are closed see our Exchange Guide section, pages 86-167.

A lot of these markets do not have the same level of technology that is available in the developed markets. Therefore, the majority of trades in many emerging and frontier markets have to be handled manually. While many companies are working on the expansion of electronic and DMA trading in these countries to ease access, it may be awhile before trading in these markets becomes as efficient as it is in developed markets. Meanwhile, because each market has its own set of rules, regulations, and restrictions, handling all the orders manually becomes strenuous, and some venues may turn away trades, rather than risk not finishing them. One of the biggest fears of trading in these markets is not finishing or settling a trade. Penalties for mistakes, not finishing a trade, or settling a trade can be very costly.

One way around these risks is establishing trustworthy, reliable relationships with reputable outsourced desks and local traders. This is a big challenge in itself, but one that can make a world of difference. A company’s local broker network can provide them with liquidity, information, and sometimes clients and is therefore essential for successful trading in both emerging and frontier markets.

As 2015 rolls in, the state of the emerging markets is in a flux. In 2013 and early 2014, the leading emerging countries like Russia, Brazil, and Turkey were hit hard by political

In certain markets,

many of which are in

the Middle East, you

must have the cash or

stock ready in advance

prior to trading; it’s

called the pre-fund.

Trading Minefields | Emerging and Frontier Markets 35

and economic uncertainty, which held investors at bay. India and some smaller emerging countries, on the other hand, are doing well at the time of this writing, especially Qatar and the United Arab Emirates.

For a more granular look at how emerging and frontier markets have been performing in the past five years, please go to the MSCI website to see their Index Performance at the following link: (You will be asked to accept the Terms and Conditions before you can see the data by clicking Agree, from there click on EFM (Emerging + Frontier Markets) or EM (Emerging Markets) on the spreadsheet to see the chart data):

http://www.msci.com/products/indexes/country_and_regional/em/performance.html

While frontier and emerging market liquidity may not account for much on the global scale, both are essential for the health of the global economy. In the past several years, the emerging markets boom has been a highlight of the global equity markets as the developed markets have struggled. They are as risky as they are rewarding, so a deep understanding of these markets, trustworthy relationships with local brokers, and a lot of patience are a must if you are to be successful trading in these markets.