Ideas & Debate

Innovative financial assets open doors to global capital markets

Investors fill application forms during a Nairobi Securities Exchange-listed firm’s past initial public offering in Nairobi. PHOTO | FILE
Investors fill application forms during a Nairobi Securities Exchange-listed firm’s past initial public offering in Nairobi. PHOTO | FILE 

Businesses source capital to meet different needs including expansion of their networks, launch new product lines, finance structural changes and infrastructure expansion.

Corporate bodies mobilise capital through domestic markets by issuing corporate bonds and initial public offerings (IPOs). However, depending on the prevailing macroeconomic conditions at play, reliance on domestic capital markets may be constrained.

As a result, the world has witnessed innovations in financial assets that offer alternative access to capital such as private equity firms, cross listings and use of depository receipts or notes to access capital from the global markets.

In Kenya, recognisable efforts include cross-border listing, an initiative adopted in the East African Community (EAC) since the signing of the Treaty for the Establishment of the East African Community in November 1999.

This has yielded positive results with seven Kenyan companies being cross-listed on securities exchanges in East Africa between 2002-2012.

More recently in 2015, the abolition of the 75 per cent threshold of foreign ownership in listed companies through amendments to the Capital Markets (Foreign Investors) Regulations has equally had a significant effect on volumes of global capital flows into Kenya. Despite these commendable strides, cross listing still faces a myriad of challenges key among them a lack of a common trading, clearing, settlement and depository infrastructure that has resulted in minimal trading in cross-listed securities in the EAC bloc.

Consequently, strategic efforts towards legal framework convergence and harmonisation of trading and settlement infrastructure has been actively pursued by the EAC member States since 2013.

However, convergence by necessity takes time, creating room for product innovation to address the gaps in the short term.

The Capital Market Master Plan (2014-2023) seeks to offer an interim solution through the use of depository receipts and depository notes by market players.

The instruments are designed to allow local corporates and foreign firms to gain access to new equity from new markets. Structurally, receipts and notes are similar, except that the underlying security for the former is equity while for the latter it is debt.

The receipts and notes can be described as negotiable financial instruments, in the case of those that are global (or outward), are issued in one country (such as the United Kingdom) and representing an interest in an underlying security or debt issued and listed in another country (such as Kenya). In effect, allowing UK investors to hold and trade in Kenyan securities or debt instruments as if they were local securities.

The underlying securities are normally held by a depository bank or by an appointed custodian in the country of issuance.

The very same logic can be applied to Kenya depository receipts (KDRs) and notes whereby securities issued in one EAC country could be made available for trade on the Kenyan markets by way of receipts or notes being listed inwards.

In the case of an inward receipts or notes, there would be an opportunity for local financial institutions to partner with global banks or issuers seeking to issue receipts or notes in Kenya.

World over, depository receipts and notes have been used by developing markets as a means of raising capital, venturing into new, promising markets, familiarising international investors with local companies and attaining global visibility.

Global depository receipts (GDRs) and notes are considered outbound as they are issued by locally listed companies seeking to raise international capital while KDRs or notes issued by foreign firms publicly listed in their jurisdiction seek to tap into the domestic liquidity.

An opportunity is thus presented for Kenyan corporates to tap into GDRs to access global markets, promoting Nairobi as an international financial hub as more foreign capital is invested in the region.

The KDRs enable local savers to diversify their investments. Institutional investors such as pension funds and insurance firms may also find an opportunity to expand their investment portfolios across different jurisdictions.

So, what is the difference between holding the underlying share of a depository receipt and the actual receipt? Essentially, depository receipts or notes and their underlying shares or bonds are the same security, as they represent identical future streams of payments.

Were markets to be perfectly efficient and integrated, their price would be identical. However, efficient capital markets remain a distant mirage due to market shortcomings and the depository receipts and notes market is not an exception.

Research conducted over the years on American Depository Receipts confirm the presence of arbitrage opportunities (though not entirely risk-free), resulting from differences between the prices of underlying securities and the receipts or notes.

Active arbitrageurs have an opportunity to take advantage of the possibility of translating depository receipts and notes into underlying shares.

It should however be noted that arbitrage opportunities are accompanied by risks such as foreign exchange risks, stale quotes, possible inherent delays in the subscription and cancellation orders and a lack of accurate, real time information.

Holding receipts or notes of a foreign company in addition has less onerous regulatory requirements than holding the actual foreign shares of the underlying securities.

The fact that the underlying securities are listed in a foreign jurisdiction would otherwise require an investor to take into consideration rules governing trading of securities in that jurisdiction when trading.

Depository receipts or notes have gained prominence in emerging markets, easing capital raising efforts by firms wishing to access foreign capital.

Through these instruments, Kenya has a prime opportunity to actively participate in shaping the landscape of world capital markets.

Moreover, as cross listing challenges are addressed regionally, it will be in the interest of local entities to consider accessing foreign capital through the depository receipts or notes.

Currently, the Capital Markets Authority has developed a draft policy guidance note for depository receipts or notes following strong interest by potential issuers to issue, list or cross-list this product on the Nairobi Securities Exchange and is looking forward to engaging more with industry players.