As the smallest economy in the Gulf, Bahrain punches well above its weight when it comes to financial services, with more than 400 banks and other financial institutions packed into the tiny island kingdom.

Much the same is true of the local capital market. Although small in regional terms, the Bahrain Stock Exchange (BSE) had a market capitalisation of $16.9bn in mid October, equivalent to about 70 per cent of the country’s $24bn gross domestic product (GDP).

Market turbulence

After a five-year period of strong growth, the exchange had a rough ride in 2008, with market capitalisation slashed by more than a third from the previous year’s peak of $27.6bn. The bourse also remains highly illiquid, with only 50 listed companies, 37 mutual funds and 12 bonds.

Although turnover has grown steadily over the past decade, to nearly $2bn in 2008, poor liquidity remains a hindrance to the development of the Bahraini stock market. On the positive side, the valuations of most stocks are attractive, with low price-to-earnings ratios across most sectors. Yet the same could be said for many exchanges in the Gulf.

“All the markets in this region are pretty immature, so Bahrain has to ask itself how it can compete with the others,” says an equity analyst for one local Islamic bank.

“It cannot do so on size. But maybe it could compete one day on maturity.”

Bahrain’s broader financial sector has developed a reputation for diversity. Niche areas of expertise include Islamic banking, insurance and asset management. This broad spread is beginning to be reflected in the local capital markets.

The government has encouraged the growth of the domestic debt market through regular issues of securities, which include sukuk (Islamic bonds), short-term Islamic leasing bonds and treasury bills.

Besides diversity, a key sign of the maturity of a market is depth. In common with many Gulf exchanges, the BSE relies heavily on local money. The challenge is to attract capital from overseas.

“The emphasis on foreign investors is very much in step with Bahrain’s aspirations to be the financial hub for the region”

Equity analyst, regional Islamic bank

Government attempts to encourage foreign investment include two recent agreements signed with stock exchanges in Dubai and Singapore, which it is hoped will encourage cross-listings between the bourses.

But perhaps the biggest fillip will come from the private sector, with the planned launch of a second major financial exchange in Manama next year.

Due to be launched in the first quarter of 2010, the Bahrain Financial Exchange (BFX) will provide commodities and currencies futures trading, and is expected to open the door to secondary trading in Islamic bonds and a new breed of Islamic derivatives. The BFX has a target of attracting about 100 listings by the end of the year.

“It will take a long time – at least a year or two – to settle in, but it is definitely a step in the right direction,” says the equity analyst. “The emphasis on foreign investors is very much in step with Bahrain’s aspirations to be the financial hub for the region.”

Wholly owned by India’s Financial Technologies, the BFX will be based in Bahrain Financial Harbour on the northern coast

The executive team is currently finalising regulatory procedures with the Central Bank of Bahrain, and began soliciting interest from potential listees in earnest after Ramadan ended in September.

“Informally, we have gauged considerable interest from investors wishing to use BFX as a platform,” says Arshad Khan, director of the exchange. “We are quite keen on something that is liquid – for example, equities – and people are also keen on Islamic products.”

Strong interest

Initially, the BFX management team hopes to build volume and concentrate on liquid, transparent products. Despite the regional interest in derivatives and other, more complex products, these will come further down the line.

“There is still not much clarity around derivatives and whether they are Islamic or not, but there is considerable appetite for cash-based products,” says Khan.

“On the first day of trading, we will offer something like index futures, and later there is the possibility of listing commodities and cur-rencies.”

Khan hopes in particular to woo Arab family businesses, and listing criteria have been drawn up specifically to attract smaller companies looking to list minority stakes on the exchange. With funding drying up from banks and private equity investors, exchanges such as the BFX are well placed to mine this rich seam, he says.

Further down the line, the BFX hopes to bring in an international investor to take a minority stake in the exchange and help develop it as a business.

In other markets, India’s Financial Technologies has partnered with US bank Merrill Lynch and Citigroup as co-investors.

Tentative discussions have been held with both regional and international companies for the BFX, but no significant negotiations have been broached. “We need to be clear about our own targets first, so we need to polish the spread sheets before hunting for strategic investors,” says Khan.