When a fledgling Dubai bourse entered a strategic relationship with one of the largest and longest-standing stock exchanges in the world in September 2007, the audacious move created large pools of liquidity stretching from North America to Asia in a single trading platform, while bolstering the emirate's chances of transforming itself into the regional financial centre of choice.

While the mutual benefits of the deal between Borse Dubai and the US Nasdaq appear clear, the structure of the deal and the economic drivers behind it are more complex.

Borse Dubai, the state-owned holding company for the Dubai International Financial Exchange (DIFX) and the Dubai Financial Market (DFM), acquired a 20 per cent stake in the US exchange along with most of the shares Nasdaq owned in the London Stock Exchange (LSE). Nasdaq took Borse Dubai's stake in Nordic stock exchange group OMX, and with it a one-third stake in the DIFX. Nasdaq in return agreed to sell Borse Dubai a 28 per cent stake in the LSE.

Borse Dubai is not the only Gulf institution peering over the horizon for partnerships with overseas stock markets. In late March, the New York Stock Exchange Euronext (NYSE Euronext) also announced a co-operation agreement with the Abu Dhabi Securities Market (ADSM).

The Qatar Investment Authority (QIA) acquired a 20 per cent holding in the LSE following Borse Dubai's deal to buy Nasdaq's stake in the UK index.

The Qataris have no desire to mount a take_over bid for the London exchange, but clearly would like to benefit from London's experience in their efforts to enhance Doha's position as a regional financial market, while gaining valuable exposure to the LSE's breadth of international listings.

Retaining capital

The international partnerships are symbolic of a structural shift in the global economy so that large volumes of capital remain in the Gulf. In previous oil booms, petrodollars quickly left the region, ending up in equity and real estate deals thousands of miles away. Now the money is staying closer to home, raising the prospect of much of it finding its way into local equity markets.

This backdrop goes some way towards explaining the interest from international bourses in building relationships with exchanges in the region.

"In the past, all they had to do was open their deposit accounts and the money flowed in," says Abdul Qadir Hussein, chief executive officer of Dubai-based Mashreq Capital, the investment and brokerage arm of Mashreqbank. "The petrodollars were recycled directly to the West either through the banking system or through investments. This time around, Western companies are having to find new ways to tap into the liquidity in the region."

The region's relative insulation from the global liquidity crunch is a key factor, with Middle East capital markets providing a useful avenue for asset diversification.

"International equity players have to provide some return to their investors and know they won't achieve that easily in the US or Europe in the short term," says Laurent Dambly, an executive director at Dubai-based investment company Arqam Capital. "They need to find alternatives, and one of those is the Middle East."

For Nasdaq, the draw of the DIFX is relatively simple. The fastest way to get the market ready is to buy an existing exchange, one that knows the system and the risks. By acquiring knowledge and experience off the shelf, the US exchange will not have to engage in a long and painful learning process.

The impetus to move fast is clear. The global exchanges eyeing the Gulf may find that one of the key attractions in the tie-ups - the Gulf markets' lack of correlation with global markets - could start to evaporate. In the early months of 2008, there have been a series of sharp falls on Gulf bourses, suggesting that the region's insulation from international economic volatility is fast eroding.

Gulf stock markets were hit by a strong bout of selling pressure in March, with the regional indices all ending the month down on the previous one. The value of shares traded on the GCC bourses decreased to $70.7bn in March 2008, compared with $91.7bn the previous month.

One of the triggers for this is that in recent years, Gulf stock markets have started opening up to international investors. Large foreign portfolio investments have flowed into the region's bourses, accentuating the correlation to global market trends. So it is no surprise to observers that the Gulf markets that have remained closed are doing the best.

The Saudi market grew by 14 per cent from 1 January to the middle of April, proving to be more insulated than most from global trends and going some way towards recovering from the dramatic correction of 2006.

Gulf investors are increasingly sensitive to the wider economic environment, even if booming hydrocarbons earnings continue to flood into regional economies. "You might have expected the markets to be buoyant this year but they have not, and that has a lot do with the fact that there has been a reduction in risk appetite," says Hussein. "Everyone is looking at the newspapers and seeing that equities are not the best place to be right now. That is where the correlation has hurt."

Regional growth

Once stability returns to global capital markets, Gulf valuations should start to improve as the correct multiples are put on the growth that is being reported in the region.

With massive hydrocarbons surpluses feeding corporate performances, there is little wrong with the fundamentals.

For the Gulf's exchanges, the impetus to pair with the global heavyweights is different. Regional stock markets have much to gain from tapping into the market expertise of Nasdaq and Euronext. Besides a market-leading brand, Nasdaq brings cutting-edge OMX technology that could give the DIFX - which has struggled with low volumes since its inception in 2005 - a significant boost.

"The motivation to tie up with major exchanges is that they get the technology, the know-how, the clearing systems and the central depository system," says Hussein. "The back office nuts and bolts that go into making an efficient exchange are given to them."

Such attractions piqued Abu Dhabi's interest in establishing a relationship with NYSE Euronext. As part of its alliance, by the end of 2008 the US-owned exchange will provide ADSM with state-of-the-art information and market infrastructure systems and technology to host all financial instruments admitted to trading on the Abu Dhabi exchange.

Tom Healy, director general of the ADSM, says the support and advice from NYSE Euronext will significantly enhance its systems operations, broaden Abu Dhabi's product offering, and assist the development of new businesses - supporting its ambition to become the premier financial market in the Gulf.

"We wanted an alliance with a major international partner where we could benefit from their experience and expertise," says Healy. "We want a broader range of instruments to trade in the market and a broader choice to give to investors. On the other hand, we believe that some foreign issuers would find our market attractive as a source of capital."

The idea is to get more foreign listings onto the Abu Dhabi market. ADSM's strategy is to focus initially on exchange-traded funds (ETFs) - essentially index-tracking funds - and to concentrate on new sectors. Diversification is the watchword. "The market in this part of the world is very focused on two sectors: financial services and real estate," says Healy. "So it seemed to us a very good idea to look for someone who will issue an ETF."

Derivatives market

Another factor that has drawn the big inter_national exchanges to the Gulf is the increase in regulatory pressure to develop derivatives markets over the past year. The exchanges are taking heed, with NYSE Euronext and ADSM set to explore the possibility.

To date, only Kuwait has a derivatives presence in the Gulf, with some futures traded on the market for a maximum of 40 minutes a day. However, the Nasdaq link-up will augment the DIFX's ambitions to turn itself into the first exchange in the region with a substantial platform for derivatives trading to be launched in the second half of 2008.

Under the plans, the DIFX will offer derivatives based on stocks listed on the exchanges, as well as equities and indices from other regional stock markets.

Derivatives might still take a long time to take root in the region. "The regulators will need to get much more comfortable with the concept," says Arqam's Dambly. "Starting up a derivatives market is not easy for any market."

Arqam itself is looking to start developing a GCC derivatives business focused on local products, a pointer to a wider appetite for derivatives in a region where the capital market is becoming more sophisticated.

However, cultural barriers remain. Short selling, for example, where a trader borrows what he considers to be over-valued securities from a lender and sells them on, only to buy them back quickly and make a profit on the decline in value, has little track record in the Middle East. It is seen by many Muslims as a form of gambling. The emergence of a derivatives market may yield a change in this attitude. European derivatives markets started out buying long (holding the shares for the long term), but when derivatives arrived, shorting quickly followed. In the Gulf, it may take a while longer, but the practice is likely to prove as popular as it is in Western financial markets.

The heightened integration between Gulf bourses and international exchanges like the Nasdaq and LSE may have other implications for the region's evolving capital markets. For one thing, it may complicate efforts to create a single Gulf equity market. Just as some Gulf states have broken ranks to strike bilateral free trade pacts with major trading partners, the biggest exchanges appear to be following their own trajectories in order to burnish their credentials as the region's pre-eminent financial centre.

The danger is that such one-upmanship could hamper the emergence of a genuine common equity market in the Gulf - an ambitious vision to turn the region into a much more significant global player on the financial markets.

Local bourses are expanding their relationships with exchanges in the GCC by signing a series of memorandums of understanding. Earlier this year, the Dubai Financial Market and the Bahrain Stock Exchange signed a memorandum to strengthen co-operation between the two bourses and encourage cross listings.

Proponents of a single Gulf equity market argue that the advantage of size - a potential market capitalisation in excess of $1 trillion and more than 600 listed securities - and efficiency would substantially boost the region's chances of capturing a much larger share of global trading.

"If there were a single currency and a certain level of convergence of regulatory standards, this would facilitate a common market in Gulf securities," says Healy. "You would not have to have just one stock exchange. The European model is developing like that: a common market in capital with competing exchanges."

Regional exchanges need to take a broader perspective and the link-ups with overseas exchanges make sense in this context.

"People are focused on their competition as being their neighbours, whereas realistically the competition is not defined by geography in an electronic market," says Healy.

He points out that as technology demolishes physical barriers, a Gulf stock market might even be located in an entirely different part of the world where there is reasonable overlap in the working day.

The recent spate of tie-ups between the regional bourses and the global giants has opened up the region to a wave of capital market innovation. The structure of the DIFX-Nasdaq deal may be complicated, but it suggests that regional authorities are ready to think ahead. They are meeting the Western exchanges' need to track the steady movement of global capital flows to the Middle East, while opening up new opportunities for regional investors to tap into a wider range of instruments, using state-of-the-art technology.

It looks like a win-win situation for the Gulf's bourses, but a process that may necessitate some interesting decisions by regulators and investors alike.

Top five GCC stocks by market cap

1. Sabic - $111bn

2. Saudi Telecom - $39bn

3. Al-Rajhi Bank (Saudi Arabia) - $35bn

4. Etisalat (Abu Dhabi) - $33bn

5. Zain (Kuwait) - $28bn

Source: Standard & Poor's; Gulfbase; MEED

Table: Exchange activity, March 2008

Source: Global Investment House

Table: GCC market cap breakdown