* Market to open in first half of next year
* Three-month consultation period for draft rules
* $580 bln market is biggest in Arab world
* 20 pct cap on combined foreign holdings in any stock
* Minimum $5 billion AUM for foreign institutions (Adds comment by fund managers, analysts)
DUBAI, Aug 21 (Reuters) - Saudi Arabia's stock market regulator proposed rules on Thursday for opening the $580 billion market to direct investment by foreign institutions, including a 10 percent cap on foreign ownership of the market's value.
Among other draft rules, a single foreign investor could own no more than 5 percent of any listed firm, while all foreign institutions combined could own no more than 20 percent. The Capital Market Authority published the draft on its website.
The Saudi market is the biggest in the Arab world and one of the last major bourses to open up, so the reform is attracting massive foreign interest. Fund managers have estimated the market could draw $50 billion or more of new foreign money in coming years if it is included in global equity indexes.
"A lot of foreign smart money will want to enter the Saudi market given that other markets might be reaching their upper limits going forward," said John Sfakianakis, a prominent Riyadh-based investment strategist.
He noted that the Saudi market was more liquid and diverse than markets in neighbouring Gulf states such as Dubai.
Authorities in the world's biggest oil exporter, keen to use the stock market to diversify the economy beyond oil and create jobs, considered opening the market for years. But they held off, concerned about the risk of destabilising stock prices.
Currently, foreigners other than residents of Saudi Arabia and citizens of neighbouring Gulf states can only invest in the market in indirect ways such as swaps and exchange-traded funds.
The Capital Market Authority (CMA) said in July it would open the market in the first half of 2015, causing a surge in the stock index which is up 10 percent since then.
It is expected to issue a final version of its rules after a three-month consultation period. The draft provides for further curbs to be placed on foreign ownership of individual stocks by "supervisory or regulatory authorities".
For example, fund managers believe foreigners may not be allowed to hold shares in certain real-estate developers with operations in the holy cities of Mecca and Medina, to ensure that non-Muslim investors do not own assets there.
Ali Adou, portfolio manager at The National Investor in Abu Dhabi, said he expected the Saudi market eventually to be included in MSCI's influential Emerging Market Index, but that the proposed foreign ownership limits might reduce its weighting within that index.
"The CMA is taking a conservative approach," he said.
The draft rules are similar to those used by some Asian markets including China as it opened up over a decade ago.
China expanded foreign participation in its market in small stages; Riyadh is expected to adopt the same approach, granting investment permits to individual institutions only gradually to avoid any sudden flood of foreign funds.
The draft says foreign institutions will have to qualify for permission to invest. For example, they would usually need to have at least $5 billion of assets under management, and investment experience of no less than five years.
Daniel Broby, chief executive at Gemfonds, a global emerging market specialist firm, said the $5 billion minimum was disappointing, and might be an effort to preserve the lucrative market in swaps that foreigners currently use to invest.
Some banks in Saudi Arabia have profited by arranging the swaps for foreigners, and under the draft rules, smaller foreign funds would have to continue to use those instruments.
The 10 percent cap on foreign ownership of the market's value could be difficult to enforce, creating uncertainty for investors, some fund managers said. Foreign ownership in some other big emerging markets is much higher, at around 20 percent or more.
For the CMA website, click on: