An international financial jurisdiction (IFJ) is a framework that is defined by regulatory, tax and legal factors. These factors combined with the overall strategy and the workforce or people behind it will determine the operating model and success of the IFJ.
In other words, the IFJ is similar to a shopping mall that provides the necessary environment for independent shops to establish themselves. The shopping mall is able to extract value from the very presence of the shops being in the mall. Similarly, the individual shops in the mall benefit, whether this is due to the facilities offered by the shopping mall or the collective customer ‘pull’ that exists by having a variety of shops clustered together.
Balance of risk and reward
The IFJ is, therefore, about creating and encouraging an environment that offers a better balance of risk and reward, thus enticing and encouraging financial and industry institutions to participate. This can be enhanced further by enabling or leveraging capital market activities. There is, however, discontinuity between primary and secondary capital market activities within the IFJ – namely, primary activities that are required to make business work (for example, lending, borrowing and capital raising) versus secondary activities (for example, trading for the sake of trading) that are not necessary for business to work but do bring transparency and, ultimately, attract additional participants to enter the market.
The precise definition and role of capital markets within the IFJ will vary from jurisdiction to jurisdiction. It is critical, therefore, to understand the exact starting position of a capital market, from which it should be possible to define and articulate the appropriate strategy or direction. (Is the market large enough or capable of growing independently and/or organically? Should specific products and services be targeted and introduced to the market?)
In Turkey, for example, there already exists a capital markets environment, including both a cash exchange and a derivatives exchange. There is an inherent assumption that the local and regional markets will naturally mature and follow the needs of the forming of Turkey’s IFJ. Ultimately, market forces will help to decide its fate.
In contrast, the Dominican Republic is launching its own IFJ in an environment that does not have the same starting point as Turkey’s for developing its capital markets. The Dominican Republic is, therefore, aiming to instigate growth for the capital markets environment within its emerging IFJ by introducing a market infrastructure entity.
Behind the strategy
Understanding the starting point and desired end point for the IFJ and its associated capital markets, however, is only part of the answer when assessing a strategy to pursue. Additional criteria can be used to establish the appropriate position that the capital market fills within the IFJ. In broad terms, the capital market and IFJ should be assessed by target geography (domestic vs international) and scope of capital market (niche vs full service).
The matrix on the opposite page sets out these parameters and includes example (albeit relative) positions of known capital markets and IFJs:
- The full-service, international capital market provides a complete range of markets, services, functions and products. In addition, both domestic and international players are active in the market, which is underpinned by internationally recognised standards and practices. The US and the UK are examples.
- The niche-service, international capital market provides a more focused environment where not necessarily all services or products are covered, but international standards are followed and both domestic and international players are active. Switzerland is an example, where the Swiss Market Index (SMI) provides a basis for a particularly focused market.
- The full-service, domestic capital market is typically supporting a large or growing domestic market. Many may have the potential to move onto the international stage, leveraging particular services and products, such as the case in Russia. Fundamental to transitioning, however, is the ability to embrace and implement international standards that are recognised and followed by international players looking for consistent risk practices and operational efficiency.
- The niche-service, domestic capital market is normally represented in an emerging or embryonic marketplace. Services, functions and products tend to be very focused on one or two key mechanisms. The emergence of the Stock Trading Center of Vietnam for cash equities and bonds is an example of such a market.
New or enhanced?
The decision of whether to introduce a new or, if appropriate, augment an existing exchange, central counterparty or central securities depository is only the first step. As noted above, much will depend on the current situation or ‘starting point’ and a view on the end state.
Determining which markets, products, intermediaries and investors are to be involved may be influenced by various aspects. These typically include factors ranging from leveraging a particular natural asset or position in the world’s economy (Qatar with its energy hub is more conducive to commodities) or contributing to part of a wider political agenda taken by a central government that is looking to enhance its brand or confirm its independence (such as, emerging or developing countries in southern Africa, south-east Asia and eastern Europe).
Infrastructure solutions
From where the market infrastructure solution hails is equally important. The well-established capital markets and their associated exchanges, clearing houses and depositories have traditionally tended to be bespoke creations, with intellectual property a closely held secret and critical to controlling their destiny. This, however, can prove to be an expensive decision and not appropriate for all markets.
Alternatively, through various advancements, particularly regarding technology, it is often more appropriate for a developing capital market to consider buying a solution, or partnering with an existing provider or market infrastructure player to establish the market.
There is no need to ‘reinvent the wheel’ when it comes to services and functions that are deemed to be commoditised. Existing exchanges, such as the Deutsche Börse, NYSE Euronext and the London Stock Exchange, have managed to either sell their software to other developing exchanges or form a partnership to in-source the business. This can provide significant benefits, ranging from timely entry into the market to conformity to market standards, proven solutions and becoming financially more attractive.
Alternatively, technology vendors, such as OMX, provide full solutions covering trading, clearing and settlement that can be leveraged.
Six key considerations
There are many factors to consider when evaluating which approach to take to establish (or enhance) an exchange, central counterparty or central securities depository. Fundamentally, there are six key aspects to consider: governance; the operating model; functionality; technology; pricing and revenue; and regulation and law. There is a whole range of variables within these criteria, such as will the operating model follow a horizontal or vertical model, what is the IT capability and on what basis will fees be levied?
A single model to suit every scenario does not exist because each market situation is unique. It is a question of considering all the variables and the weighting of each to achieve the best result.
