Bonding exchanges

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Exchange consolidation is one global trend that seems unaffected by the credit crisis, as a likely tie-up between the Johannesburg Stock Exchange (JSE) and the Bond Exchange of South Africa (Besa) may soon prove.

"Integrating Besa and the JSE is in line with bourse consolidation around the world," declared Nicky Newton-King, the JSE's deputy chief executive, in a statement last October that heralded the beginning of its bid for the fixed-income exchange. Not only would a union of the JSE and Besa improve South Africa's competitive ability in an increasingly international market for securities trading, it would also create "compelling synergies", she said.

For their part, customers will benefit from lower trading costs, greater liquidity and an expanded product offering, the JSE claims. This would help to grow the South African interest rate market and also fend off strong competition from the offshore and over-the-counter markets.

In late October 2008, the JSE made an all-cash offer of R90 ($9.11) a share, valuing Besa at R173.22 million. The bid was swiftly rebuffed by Besa's management and its largest shareholder, the New Zealand Stock Exchange (NZX). However, a 39% increase in the offer, to R125 a share, led Besa's board to recommend the takeover bid on December 10. "On the basis that the shareholders want it, and that the offer was towards the top of the value range as determined by independent advisers, we recommended it and we are co-operating with the JSE to get it through," says Garth Greubel, Johannesburg-based chief executive of Besa.

As Risk South Africa went to press, the JSE had irrevocable undertakings from 77% of Besa's shareholders. Barring objections from local regulators, the tie-up should occur during the first half of 2009, Greubel adds.

In line with JSE plans, the combined exchanges will embark on a bond market growth strategy, involving a review of the products offered by both Besa and the JSE's rival interest rate market, Yield-X. It will also investigate the market models they employ and the technical infrastructure available to the new group.

The tie-up will be the latest event in a period of change for Besa, which demutualised with the approval of its members in October 2007. Since reporting an operating loss of R1.7 million at the end of 2007, the exchange has been working on an expansive growth strategy, backed by a rights issue that raised R80.8 million from the firm's strategic partners, including NZX, last October.

Joint ventures

Among other things, the strategy involves the establishment of BondClear, a joint venture with New York- and Stockholm-based exchange trading and technology firm Nasdaq OMX. BondClear will act as a central counterparty and will provide post-trade administration services for the interest rate derivatives market, building on technology already developed by Nasdaq OMX. "It brings proven technology into the market - technology that's already running and has proven to be robust during the credit crisis," says Greubel.

The venture may be timely, given broader unease about counterparty risk following the demise of Lehman Brothers last September. Currently, trades on Besa are bilaterally cleared among the exchange's members. The firm also has a guarantee fund, which compensates members should trades fail to go through properly.

This means the maximum credit enhancement that can be attained for interest rate trades conducted on the exchange is equivalent to the international credit ratings of the country's main dealers - mostly rated Baa1 by Moody's Investors Service. BondClear will pierce this ceiling by using the Swedish balance sheet of Nasdaq OMX, which is rated A+ by New York-based Standard & Poor's (S&P) - the equivalent of an A1 rating from Moody's. As the clearing-house's balance sheet will be located in Sweden, any trades cleared will also benefit from reduced sovereign credit risk.

Although the plans are currently in flux pending the JSE merger, the development could eventually entice more foreign market players to use the exchange, says Greubel. "You get credit enhancement through that, with the result of increased country limits and greater capacity for the non-resident to trade in this market," he says. As of early February, South Africa carried a BBB+ foreign currency rating on a negative outlook from S&P, while Sweden had a stable sovereign rating of AAA.

The clearing house is currently being set up and Greubel claims a number of banks have signed letters of intent to become members. The system could also be extended to repo transactions and eventually spot bond trades, he says - but this will also depend on the outcome of the JSE's likely review.

More recently, Besa launched Africa's first binary options exchange, called Justrade.com. The website is intended to cater for the country's growing retail market. "It's a great little piece of technology and a really exciting product," Greubel remarks.

Retail clients can use the website to take exposure to changes in economic indicators, such as the country's main interest rate, as well as the price of local stocks. "We have binary options on JSE-listed equities and for R100 you can take exposure to them. There's no other method in this country to take exposure so cheaply," says Greubel.

While declining to give figures, he claims Justrade.com is growing at a rate of 50% month-on-month, albeit from a low base. Although Besa's licence is restricted to financial products, Greubel adds the intention is to eventually extend the project into other areas, such as sports betting.

In its core market, Besa enjoyed a year of record secondary market bond trading during 2008. Turnover in bonds rose by 39% compared with 2007, reaching R19 trillion. "From a turnover point of view, our market has been very, very liquid," says Greubel. "We're turning over our bond market capitalisation more than 2.5 times a month." Perhaps unsurprisingly given the recent outflow of capital from emerging markets, overseas participants decreased their level of participation during the year: from a peak of 46% in September, the proportion of foreign purchases and sales of bonds fell to 34% in November and finished 2008 at 35%.

When it comes to primary bond listings, investor caution seems to have deterred some business in 2008. During the year, the nominal value of bonds listed increased by 5.6%, to R824 billion - substantially lower than the 33% growth the year before. "The credit crisis has caused spreads to blow out, which has definitely slowed the number of new issues in vanilla corporate bonds," says Greubel. Consequently, both issuer and investor attention has focused on the short end of the curve, he says. Indeed, despite the overall decline in bond listings, the nominal value of commercial paper issuance was up by 36% last year.

Badly burnt

One area of new listings has been particularly badly charred by the credit crisis. Even after rating agencies began to downgrade US subprime mortgage-linked securities en masse in July 2007, securitisation had been doing well in South Africa. In recent years, annual securitisation issuance has risen by about one-third year-on-year. By 2007, issuance climbed to R41.07 billion, according to Absa Capital. But in 2008, credit fears and investor concern slashed issuance to just R4.88 billion - its lowest level since the country's first securitisation of residential mortgages in 2001.

"The great tragedy was that our securitisation sector was a really great market, and we've seen an aversion to securitisations over here because of what's happened offshore," says Greubel.

South Africa's securitisation business was still at an early stage in its development and did not include the kind of complicated structures that triggered the global crisis, such as collateralised debt obligations, he says. Meanwhile, most of the underlying assets were of sound quality, unlike many US subprime mortgages.

"Our market has been fundamentally different, but we have still been painted with the same brush. There was good underlying asset quality and strong cash flows," he asserts. While not daring to predict exactly when the domestic market will recover, he hopes the performance of underlying assets may eventually lead investors to return.

Among local market participants, the ongoing development of South Africa's corporate bond sector has often fostered talk of a domestic market for high-yield bonds. Nonetheless, as Greubel notes, it has never quite taken off. "There's a chicken-and-egg situation," he says. Investors are loath to buy high-yield bonds until there are a sufficient amount of other participants in the market to ensure they do not suffer from over-concentration to a single issuer. On the other hand, high-yield issuers are unlikely to come to market until investor interest has picked up and they are assured of reasonable spreads, he says.

Traditionally, these adverse economics have meant South African corporates prefer to issue high-yield bonds in Europe. But with investors wary of emerging market issuers, Greubel speculates some entities might be tempted to tap the local market. "Maybe the blowing-out of spreads in Europe will be the catalyst that causes some of those companies to try to issue here," he says.

Whether this is the case or not, it seems that Besa, the JSE and local market participants all agree there is room for further growth.

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