A recent report shows that Tadawul, the Saudi Stock Exchange surpassed the London bourse to become the world’s second busiest market for initial public offerings in the first five months of 2008. According to Reuters, the total of Tadawul IPOs rose 322 per cent from a year earlier to $8.50 billion. This notable increase was on the back of high profile IPOs such as Al Inma Bank, which raised $2.80 billion, the $1.87 billion listing of mobile telecom company Zain, and the $1.20 billion IPO of petrochemical company Petro Rabigh.

Although the number one spot was occupied by the New York Stock Exchange, thanks largely to the $19.70 billion listing of Visa, the Saudi Exchange’s grand entry on to the world stage is nothing short of spectacular.

With this phenomenal growth in fund raising, Tadawul has been thrust at the centre of the global market’s attention. Its current market capitalisation of over $490 billion makes it one of the largest emerging market exchanges.. There are 119 companies listed on the bourse and the average value of shares traded this year currently stands at almost SAR 10 billion per day.

Today, it is at a defining moment in its history. As the bourse strives to continue to be a leading exchange for IPOs, the opportunity is ripe for Tadawul’s management to build on its success so far and take the exchange business to a new level that is scaleable, profitable and diversified.

Tadawul is a regulated entity, overseen by the Saudi Capital Market Authority. Globally, regulatory rules are far from uniform across different jurisdictions, and the involvement and goals of regulators also differ. However, in most cases, regulators have the function of market oversight, with the objective of providing a framework of rules or laws, and the power to enforce or even prosecute for the orderly functioning of financial markets (e.g., ensuring fairness among market participants). Furthermore, in particular for cash markets like Saudi Arabia, with a high degree of retail involvement, there is an additional objective of protecting the consumer, the small investor.

The exchange business is a profitable one if managed efficiently along the pillars of cost rationalisation, revenue growth through product development and strategic acquisitions. It is a volume-driven business where economies of scale matter and there is usually scope for further efficiency gains to support earnings growth.

On a global average, the exchange business has a return on equity of over 24 per cent. The 22 listed exchanges have witnessed a revenue growth of over 17 per cent in the past five years while costs have increased by a shade over eight per cent.

The profitability of the exchange business shows that there is great opportunity ahead for Tadawul, which has the potential to grow aggressively in the next five years and be a dominant, highly profitable regional exchange. It appears that the Saudi exchange is well-positioned to develop an “integrated” offering for traditional market opportunities.

Going forward, Tadawul must target revenue diversification through aggressive product development, strategic stakes in regional exchanges with strong product portfolios and acquisition of fast growing niche exchanges or trading platforms that trade products with little or no correlation to the existing portfolio (e.g. energy, commodities, weather, etc.).

As well, Tadawul will need to identify and implement sources of incremental revenue. Its product portfolio needs to be enhanced to include derivatives, fixed income, exchange traded funds, real estate investment trusts, an Islamic Securities Platform, and new investable benchmarks.

For Tadawul, structural drivers for volume growth are in place in the form of a robust economy, a growing capital market and increased demand for capital from new issuers and listed companies. Over the years, the Exchange has deployed substantial resources towards development of IT infrastructure, a new trading platform and risk management system. However, continued strong volume growth may come in conjunction with higher fee attrition than currently anticipated as the participants put pressure on pricing.

Historically, most exchanges have had dominant positions in their respective markets. In today’s financial markets characterised by rapidly developing technology and a diverse client base, lower marginal costs have become increasingly important. In such a scenario, when exchanges, like Tadawul, offer new products and expand into different geographies, a strong and innovative management team can make a difference on earnings growth of an exchange.

Tadawul must offer a comprehensive and efficient infrastructure to issuers for raising capital and to investors for transacting and clearing financial products. As a leading marketplace, it must strive to continually innovate and provide its customers (issuers, investors, broker-dealers) with convenient access to quality products and the best price discovery and liquidity at a competitive cost while seeking to create value for its shareholders.

The time has now come for Tadawul to consolidate its status as a global growth market, reposition itself and restructure its business model for the next phase of its growth.

The opinion expressed is that of the author himself and does not necessarily reflect that of the organization ( Morgan Stanley) he represents.