Mongolian stand-off flags frontier market issues

The suspension of half of Mongolia's broker community by the local exchange last month has highlighted the problems faced by those trading frontier markets.
Mongolian stand-off flags frontier market issues

The current stalemate between the Mongolia Stock Exchange (MSE) and its members – which has seen half the local broking community suspended – has dramatically underlined the problems foreign firms face when trading frontier markets.

Admittedly, Thomas Hugger, chief executive of Hong Kong-based Asia Frontier Capital, says he hadn’t previously encountered such an occurrence in his 35-year career in finance. But the situation reflects the kind of challenges that both asset managers and custodians providing execution outsourcing services can encounter in respect of frontier markets.

“I could not deal in Mongolia stocks for a week, as many of these brokers were suspended by the stock exchange,” notes Hugger. “Luckily, we always have a second, back-up broker in most of the 10 frontier markets we trade in. Otherwise, there is nothing you can do… just tough luck!”

The spat was sparked by the MSE demanding a five-fold increase in annual membership fees to $2,500 from $500 last year. The Mongolian Association of Securities Dealers, which has 54 broker-dealer members, responded by threatening an industry strike if the bourse were to go ahead with the move.

The MSE proceeded to announce on July 1 that it was suspending all broker-dealers from trading, apart from 29 that had continued to pay membership fees this year. After a week, however, the exchange agreed to set up a special working committee to review the proposed fee rise – the review remains ongoing.

As many global brokers do not yet operate in frontier markets, asset managers must often trade them via local brokers, which are often influential in their domestic markets, providing market colour on flows or access to local corporates.

But bankers and traders often cite trustworthiness and accountability issues when dealing with local brokers in certain markets. They say front-running is especially rampant in countries such as Bangladesh, India and the Philippines, as local brokers often trade on information they pick up from their foreign clients.

“It could be so rampant that some of these local brokers are just trading on any particular information they picked up from head traders of foreign asset managers,” says Hugger, whose $4 million AFC Asia Frontier Fund trades markets such as Bangladesh, Cambodia, Laos, Mongolia and Sri Lanka.

Traders also say they lose time-to-market, as local sales traders may not be able to execute orders due to unreceived emails or outages (or claims of them). Hugger says he would prefer trading through expatriates who work at local brokers, rather than local employees, to be confident that his orders will be executed securely and in his clients’ best interests.

Another issue cited by traders is that some local brokers are under-capitalised and therefore may not be able to fund a big transaction for an asset manager before the securities get settled in the manager’s custodian account. (Custodians usually pay brokers on a T+2 settlement basis – that is, two days after trade day.)

Some managers even assume the counterparty risk of pre-funding the trade themselves before receiving the securities – if they trust the broker not to make off with the money or go bankrupt.

Moreover, reputation risk is a concern for global custodians, which often provide execution-outsourcing services to asset managers, when working with frontier-market brokers.

Bruno Campenon, head of BNP Paribas Securities Services in Hong Kong, says: “We need to ensure that our know-your-customer processes and internal controls for anti-money laundering are robust enough to safeguard against reputation risks from local brokers.”

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