Russia
19 October 2010
Russia鈥檚 enormous potential is being reached more slowly than was first anticipated, and there鈥檚 still work to be done if its securities lending industry is to become a major player on the world stage
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Russia remains a country of contrasts and unpredictability. It has one of the world鈥檚 greatest reserves of natural resources, and many of the world鈥檚 billionaires are Russian. Its economy has performed reasonably well over the past decade, and even during the financial crisis of the past couple of years it has done ok. It has an educated and international-looking population, and the reforms over the past few years have encouraged more and more inward investment.
Yet many international firms are reluctant to get involved. As communism fell, Russia was by far and away the largest country - both in terms of size and economy - to enter the global markets and it became a kind of experiment for the free market economic thinking of the Chicago School. Hundreds of firms were privatised, and financial markets were opened up.
But maybe this happened too quickly. International investors remain wary of the sometimes shoddy regulatory structure of many financial instruments, and afraid that regular political interference will affect their holdings. While some of the country鈥檚 elite have become very wealthy indeed, many of Russia鈥檚 population remain on or below the poverty line. And although the 鈥榃ild West鈥� atmosphere that allowed virtually anything to go in the early 90s has largely disappeared, many respectable finance houses don鈥檛 want to run the risk of being tarnished by dealings with some firms. There are also concerns that there appear to be one rule for domestic firms, and another for international players.
Russia is a huge market and an enormous opportunity. It has certainly officially opened its doors to the wider world. But there remain fears that those doors may be revolving.
Attempts to organise the securities lending market on the Russian market have been ongoing ever since the company emerged from the ravages of the Soviet Union, but so far this market segment has not yet developed enough to meet the potential demand.
This is down to a number of reasons, but chief amongst them is that the regulatory infrastructure is simply not yet there. The securities lending mechanism is not legitimised, which scares away many of the international players, as well as domestic beneficial owners who need the safety of a regulatory mechanism to ensure their portfolios are protected.
鈥淵ou have to remember that Russia has come a long way in the last 20 years,鈥� says one manager of a private office in Moscow. 鈥淭he likes of the US and the UK have had a century or more to get their infrastructure in place, while we have had less than 20 years. When the market reforms were introduced [at the time Russia became a capitalist economy], mistakes were made and we have had to take our time to get them resolved. But it鈥檚 a slow process, with a lot of vested interests and securities lending is not at the top of the agenda.鈥�
The financial crisis of August 1998 looms large in the memories of many investors. Because there were no mechanisms in place to protect lenders, significant losses ensued, and many participants are still avoiding the market as a result.
In a report on the Russian market by the Center for the Study of Financial Market Evolution, executive director Ed Blount said the problems of 1998 have still not been resolved. 鈥淒omestic securities traders are unable to create efficient short positions, either for the kind of dynamic hedging strategies that are needed to service the growth of domestic institutions or for the kind of programme-based proprietary strategies which support liquidity in domestic markets,鈥� he argued.
Currently Russian securities legislation doesn鈥檛 specify a legal relationship for securities lending; they are generally organised as a sort of combination of purchase-sale relations. As a rule, these deals are stipulated by repo contracts, ie, a purchase-sale contract, including a provision that obligates the 鈥榣ender鈥� to buy back the securities on appropriate date and at a fixed price.
Problems arise when attempting to apply a legal model of the loan or a commercial credit to the securities. Usually the securities borrowed or those purchased with an obligation of the owner to buy them back, are not sensitive to short-term fluctuations of the market demand or dependant on strategic investors will be sold immediately after their delivery.
On the date of execution of obligations under loan or on a buyback date, in order to meet the obligation an appropriate amount of securities to be returned is purchased and returned to the beneficiary-owner.
Here, though, there are constraining factors that make such big operations very risky for market participants: they have to provide a collateral in the form of liquid assets (other securities or cash) or buy out an appropriate quantity of securities for loan settlement. Secondly is the issue of the two competing Russian depositaries.
鈥淭wo depositaries just doesn鈥檛 work,鈥� says a representative of one of the depositaries. 鈥淚t makes it far more complicated for regulators, it makes it far more complicated for domestic investors, and it makes it virtually impossible to build up a securities lending infrastructure that will attract international players. One of them needs to go. Of course, I hope it is the other one [that pulls out], but to be honest it doesn鈥檛 really matter which one takes on the responsibility and which one leaves the market, so long as the situation is resolved.鈥�
Popular stocks
Global investors are very active in borrowing shares of major Russian securities firms, particularly those of Yukos and VimpelCom, in order to create short positions, says Blount. Many outsiders might automatically assume that short sales would tend to depress the prices of these two Russian companies and translate negatively into the Russian domestic markets. In fact, by using a proprietary database of global securities loan activity, precisely the opposite can be shown to have happened.
Just as was evident for American securities in American markets, many global short-sellers created market liquidity for Russian securities and contributed to price cushioning when market prices turned downward. In all likelihood, the arbitrage effect of this activity also translated its beneficial impact to the Russian domestic markets. Equally likely, a similar cushioning in the domestic markets could have taken place directly, if the Russian markets enabled the borrowing and shorting of domestic Russian securities, not just for these two issues, but also for many other liquid Russian securities issues.
Beneficial owners
The use of investment funds by private investors in the country is growing - and in fact that growth has been impressive considering such vehicles were literally unheard of 20 years ago - but as with much of the Russian economy, many of the moves are being driven by the very wealthy.
Private offices make up much of the investable wealth in the country, yet these offices tend to be more international in outlook than the domestic funds. While they do continue to invest in the country, this is often down to the political atmosphere.
鈥淲e involve ourselves through our service providers in securities lending in many territories in Europe and Asia, although not so much in North America,鈥� says the private office manager. 鈥淲hile we do invest significantly in Russia, we do so more because we don鈥檛 want to attract attention for sending our money overseas and as such, because there are issues around securities lending, we have a valid reason for not getting involved in it - and while we would like to have the opportunity to carry out transactions, it is not now or ever going to be the primary focus of our business.鈥�
International funds focusing on Russia are growing, but there hasn鈥檛 been the demand here that has been seen in other emerging economies such as Brazil. One fund prospectus details the 鈥減otential鈥� for expropriation, dilution, devaluation, default or excessive taxation by the Russian government, plus other risks, which include but are not limited to convertible and debt securities risks; market trends risks; price volatility risks; other investment companies risks; settlement and custody risks; inability to sell securities risks; and securities lending risks.
As a result, international activity remains small. Currently, securities lending is associated with the following types of risks:
non-return risk, and risk related to non-exercising rights, such as voting rights, right for dividends or other incomes. In addition, there are also issues related to taxation of income/loss derived from securities lending operations.
鈥淚n the current climate, the emphasis is on protecting the value of the fund,鈥� says one London-based fund manager with significant exposure to Russia and many Eastern European markets.
鈥淲e know that Russia has huge potential and we want to be a part of that. So a couple of years ago we may have taken the risk and got involved in securities lending to bring in extra income, but today we just can鈥檛 - our investors want us to make money for them, but more importantly they don鈥檛 want us to lose the money they have invested and we simply cannot justify the exposure that securities lending in Russia gives us.鈥�
Yet many international firms are reluctant to get involved. As communism fell, Russia was by far and away the largest country - both in terms of size and economy - to enter the global markets and it became a kind of experiment for the free market economic thinking of the Chicago School. Hundreds of firms were privatised, and financial markets were opened up.
But maybe this happened too quickly. International investors remain wary of the sometimes shoddy regulatory structure of many financial instruments, and afraid that regular political interference will affect their holdings. While some of the country鈥檚 elite have become very wealthy indeed, many of Russia鈥檚 population remain on or below the poverty line. And although the 鈥榃ild West鈥� atmosphere that allowed virtually anything to go in the early 90s has largely disappeared, many respectable finance houses don鈥檛 want to run the risk of being tarnished by dealings with some firms. There are also concerns that there appear to be one rule for domestic firms, and another for international players.
Russia is a huge market and an enormous opportunity. It has certainly officially opened its doors to the wider world. But there remain fears that those doors may be revolving.
Attempts to organise the securities lending market on the Russian market have been ongoing ever since the company emerged from the ravages of the Soviet Union, but so far this market segment has not yet developed enough to meet the potential demand.
This is down to a number of reasons, but chief amongst them is that the regulatory infrastructure is simply not yet there. The securities lending mechanism is not legitimised, which scares away many of the international players, as well as domestic beneficial owners who need the safety of a regulatory mechanism to ensure their portfolios are protected.
鈥淵ou have to remember that Russia has come a long way in the last 20 years,鈥� says one manager of a private office in Moscow. 鈥淭he likes of the US and the UK have had a century or more to get their infrastructure in place, while we have had less than 20 years. When the market reforms were introduced [at the time Russia became a capitalist economy], mistakes were made and we have had to take our time to get them resolved. But it鈥檚 a slow process, with a lot of vested interests and securities lending is not at the top of the agenda.鈥�
The financial crisis of August 1998 looms large in the memories of many investors. Because there were no mechanisms in place to protect lenders, significant losses ensued, and many participants are still avoiding the market as a result.
In a report on the Russian market by the Center for the Study of Financial Market Evolution, executive director Ed Blount said the problems of 1998 have still not been resolved. 鈥淒omestic securities traders are unable to create efficient short positions, either for the kind of dynamic hedging strategies that are needed to service the growth of domestic institutions or for the kind of programme-based proprietary strategies which support liquidity in domestic markets,鈥� he argued.
Currently Russian securities legislation doesn鈥檛 specify a legal relationship for securities lending; they are generally organised as a sort of combination of purchase-sale relations. As a rule, these deals are stipulated by repo contracts, ie, a purchase-sale contract, including a provision that obligates the 鈥榣ender鈥� to buy back the securities on appropriate date and at a fixed price.
Problems arise when attempting to apply a legal model of the loan or a commercial credit to the securities. Usually the securities borrowed or those purchased with an obligation of the owner to buy them back, are not sensitive to short-term fluctuations of the market demand or dependant on strategic investors will be sold immediately after their delivery.
On the date of execution of obligations under loan or on a buyback date, in order to meet the obligation an appropriate amount of securities to be returned is purchased and returned to the beneficiary-owner.
Here, though, there are constraining factors that make such big operations very risky for market participants: they have to provide a collateral in the form of liquid assets (other securities or cash) or buy out an appropriate quantity of securities for loan settlement. Secondly is the issue of the two competing Russian depositaries.
鈥淭wo depositaries just doesn鈥檛 work,鈥� says a representative of one of the depositaries. 鈥淚t makes it far more complicated for regulators, it makes it far more complicated for domestic investors, and it makes it virtually impossible to build up a securities lending infrastructure that will attract international players. One of them needs to go. Of course, I hope it is the other one [that pulls out], but to be honest it doesn鈥檛 really matter which one takes on the responsibility and which one leaves the market, so long as the situation is resolved.鈥�
Popular stocks
Global investors are very active in borrowing shares of major Russian securities firms, particularly those of Yukos and VimpelCom, in order to create short positions, says Blount. Many outsiders might automatically assume that short sales would tend to depress the prices of these two Russian companies and translate negatively into the Russian domestic markets. In fact, by using a proprietary database of global securities loan activity, precisely the opposite can be shown to have happened.
Just as was evident for American securities in American markets, many global short-sellers created market liquidity for Russian securities and contributed to price cushioning when market prices turned downward. In all likelihood, the arbitrage effect of this activity also translated its beneficial impact to the Russian domestic markets. Equally likely, a similar cushioning in the domestic markets could have taken place directly, if the Russian markets enabled the borrowing and shorting of domestic Russian securities, not just for these two issues, but also for many other liquid Russian securities issues.
Beneficial owners
The use of investment funds by private investors in the country is growing - and in fact that growth has been impressive considering such vehicles were literally unheard of 20 years ago - but as with much of the Russian economy, many of the moves are being driven by the very wealthy.
Private offices make up much of the investable wealth in the country, yet these offices tend to be more international in outlook than the domestic funds. While they do continue to invest in the country, this is often down to the political atmosphere.
鈥淲e involve ourselves through our service providers in securities lending in many territories in Europe and Asia, although not so much in North America,鈥� says the private office manager. 鈥淲hile we do invest significantly in Russia, we do so more because we don鈥檛 want to attract attention for sending our money overseas and as such, because there are issues around securities lending, we have a valid reason for not getting involved in it - and while we would like to have the opportunity to carry out transactions, it is not now or ever going to be the primary focus of our business.鈥�
International funds focusing on Russia are growing, but there hasn鈥檛 been the demand here that has been seen in other emerging economies such as Brazil. One fund prospectus details the 鈥減otential鈥� for expropriation, dilution, devaluation, default or excessive taxation by the Russian government, plus other risks, which include but are not limited to convertible and debt securities risks; market trends risks; price volatility risks; other investment companies risks; settlement and custody risks; inability to sell securities risks; and securities lending risks.
As a result, international activity remains small. Currently, securities lending is associated with the following types of risks:
non-return risk, and risk related to non-exercising rights, such as voting rights, right for dividends or other incomes. In addition, there are also issues related to taxation of income/loss derived from securities lending operations.
鈥淚n the current climate, the emphasis is on protecting the value of the fund,鈥� says one London-based fund manager with significant exposure to Russia and many Eastern European markets.
鈥淲e know that Russia has huge potential and we want to be a part of that. So a couple of years ago we may have taken the risk and got involved in securities lending to bring in extra income, but today we just can鈥檛 - our investors want us to make money for them, but more importantly they don鈥檛 want us to lose the money they have invested and we simply cannot justify the exposure that securities lending in Russia gives us.鈥�
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