The move was widely viewed as a bail-out option for cash-strapped Russian banks, which, according to Moscow-based securities firm Troika Dialog, were short some $6.5 billion in currency forwards offered as currency hedges for foreign investments in short-dated Russian rouble government bonds (GKOs).
Russia’s Supreme Arbitration Court deemed the contracts unenforceable under article 1062 of the Russian civil code that covers gaming and betting, and many local banks failed to meet their obligations.
But this hasn’t stopped Russian companies and direct foreign investors in the world’s largest country from using over-the-counter derivatives in offshore locations. Such deals are typically transacted via London or New York, and often linked to companies domiciled in Cyprus – a favourite offshore location for Russians.
Foreign exchange transactions, primarily rouble/dollar and to a lesser extent rouble/euro derivatives, and a raft of tools such as credit-linked notes and total return swaps that allow foreign direct investors to access the domestic fixed-income markets, are the most active areas – an estimated minimum of $3 billion of foreign investment in such credit instruments has taken place this year, according to Moscow bankers.
And a lot of lending to major Russian corporates is structured with embedded derivatives. For example, a Russian oil company that could borrow at Libor plus 400 basis points may take the options of paying Libor plus 200bp and x% in the change in oil prices. The use of OTC equity derivatives is also more prevalent with foreign banks such as Credit Suisse First Boston (CSFB), Citigroup and Dresdner Kleinwort Wassertein; and especially UBS, through its local Brunswick equities unit, Deutsche Bank via its 40% holding in United Financial Group and Moscow-based Renaissance Capital.
In foreign exchange, turnover in the cash rouble/dollar has become highly liquid by emerging market standards, with an average of $1.5 billion to $3 billion and highs of $7 billion traded per day – despite aggressive Central Bank of Russia (CBR) intervention this year.
This liquidity supports a large offshore derivatives market in London, which sees daily transaction notional volumes of around $0.5 billion. Most transactions take place between European and US counterparties, some of which have offices in Russia.
But hedge funds and asset managers with no Russian presence are also active, and an increasing number of Singaporean and Japanese counterparts are also becoming important participants. Citigroup, Deutsche Bank, CSFB and Dresdner Kleinwort Wasserstein are all major dealers in this area.
By contrast, Russian institutions have only limited over-the-counter participation, but they can tap into local derivatives trades on Russian exchanges such as the Moscow Interbank Currency
Exchange (Micex) – where many local export companies are forced to convert at least 25% of their export revenues into roubles within 90 days – although daily derivatives turnover in the first five months of this year is less than $1 million. More importantly, Russian banks can now conduct forex derivatives speculative and hedging activities via the Chicago Mercantile Exchange (CME).
Deutsche Bank’s Moscow-based head of global markets for Russia and the Commonwealth of Independent States, Yuri Soloviev, was the driving force behind the establishment of a non-deliverable currency forwards market in Chicago, say senior Russian bankers.
“We did it specifically to allow the Russian banking sector to start hedging interest rate and currency risk,” Soloviev tells Risk. “Western counterparties trade between each other OTC, but they have relatively limited lines to Russian institutions due to their credit ratings, other risk factors and their overall perception of the Russian banking community,” he adds. As a result, Deutsche has a ‘soft’ market-making arrangement with the CME where it supports both sides of the contracts for 22 hours per day.
Citigroup is also active. A rouble/dollar option was also registered in Chicago in the past 12 months and is soon to be offered by the CME’s electronic trading platform Globex. A lot of interest in the forwards is also generated by western automakers, brewing companies and supermarket chains that operate in Russia and have rouble receivables they want to hedge, Soloviev adds.
But as Russian counterparty credit ratings improve – Standard & Poor’s raised Russia’s sovereign rating from ‘BB+’ to ‘BBB–’ in January this year – increased flows may be witnessed in the OTC market, especially by state-controlled banks such as Sberbank, Vneshtorgbank, Gazprombank and privately owned Alfa Bank.
Credit-linked notes – often containing embedded derivatives – credit derivatives and total return swaps are also extremely popular. “We are doing these in tremendous size,” says Deutsche’s Soloviev. Citigroup, which has a balance sheet of around $3 billion and $400 million of capital in Russia, and, notably did not withdraw from the country during 1998 unlike most of its peers, is again a very large participant. Other institutions such as ABN Amro are also building their presence.
Scaling the size of the market is difficult, although bankers say foreigners own about 30% of actively traded domestic Russian debt. With the rouble corporate bond and municipal debt market valued at around $7 billion and the quasi-tradable government bond market valued at around $10 billion, foreign investors probably have a notional size of more than $5 billion.
The figure was likely to have been higher last year when the rouble appreciated 8.4% against the dollar. But intervention by the CBR, which already built up its forex reserves by $24 billion last year and saw its total reserves hitting $88.5 billion by mid-2004, has devalued the rouble as part of an effort to make domestic producers relatively more competitive, and this has deterred some foreign investors.
Goldman Sachs, Morgan Stanley and Entergy-Koch Trading – currently being bought by Merrill Lynch – have all actively touted customised commodity hedges to large metal producers, oil and gas majors, and the Russian Ministry of Finance, whose reserves are largely dependent on commodity prices. Although few large transactions have taken place – partly due to the reluctance of Russian companies to unveil hedging losses in their financial results at a time when commodity prices are rising steeply – the firms have had some success with equity investors whose dividends are also dependent on strong commodity prices, according to one US investment banker.
These so-called client-driven, often highly customised, pockets of deals are described by London and Moscow-based dealers as ‘extremely lucrative’. Obtaining examples of derivatives deals in this opaque market is difficult. But offering a flavour of the overall market, an insider at a large European bank says it has issued a fully collateralised loan to a Standard & Poor’s BB- rated Russian oil major via a Cyprus special-purpose vehicle that charged 625bp above Libor. By contrast, buying credit default protection on Russian state-controlled energy major Gazprom would have cost around 345bp over Libor in mid-September.
Change in legislation
But the dynamics of the market look set to change – albeit slowly. A number of initiatives are in the pipeline to amend legislation in the Russian Federation’s civil code, and in the future other laws are due to be passed to ensure non-deliverable derivatives will not be negatively affected by the country’s anti-gaming legislation. The potential impact on the offshore market could prove significant, and force a number of banks, notably those that reduced the scale of their operations in the country after 1998, to beef up their Moscow operations.
There are at least two major initiatives aimed at developing a legal framework that would make the trading of non-deliverable OTC derivatives in Russia legally viable. The first is to introduce comprehensive new derivatives legislation. The other is to amend current laws such as the civil code and banking and insolvency laws to provide legal protection for non-deliverable derivatives contracts traded off-exchange.
The first initiative was set up by a group of banks, spearheaded by Alfa Bank – Russia’s largest privately owned bank, with assets of $5.9 billion at the end of last year and, it says, one of only a handful that did not renege on its currency forward contracts in 1998.
In 2002, this group, which also included Uralsbank, retained two consultants, then working for PricewaterhouseCoopers, to prepare a draft ‘Federal Law on Derivatives’ to build a unified legal platform in Russia. The group was strongly supported by the chairman of the Russian Federation state Duma – Russia’s lower parliamentary house – property committee Viktor Pleskachevsky.
The idea was to ensure that a judge, in say, far-away Siberia, who had no previous knowledge of a derivatives product would be bound to make judgements by following explicit rules regarding legal enforceability rather than interpret a more general law. The joint working group prepared amendments to the Russian civil code and more than 40 other laws, plus a draft law ‘on ensuring the performance of financial obligations’ and ‘on mutual offsetting (netting)’, according to Simon Vine, deputy head of investment banking at Alfa Bank.
But Robert Pickel, chief executive of the International Swaps and Derivatives Association, described the plan as “ambitious” in a letter dated July 24, 2003, to Pleskachevsky. He also described the proposals as “risky”, unless there was adequate time for comment from the international community. By then, another initiative, supported by Vladimir Tarachov, then deputy chairman of the Duma’s credit organisations and financial institutions committee, proposed a more simple solution by merely amending current legislation.
The presidential elections held in Russia on March 14 delayed the process, and saw both Pleskachevsky and Tarachov take more of a backseat role in pressing ahead with reforms. “There is no visible progress. Maybe we will see something in 2005,” says Citigroup’s head of securities trading and money markets in Russia, Anatoly Shvedov.
But matters may become clearer following a Duma hearing on the subject on September 27 – after Risk went to press. A number of independent experts are due to appear at the meeting, including Anatoly Aksakov, vice-chairman of the state Duma credit organisations and financial markets committee, who is now the driving force behind Tarachov’s initiative.
Sergei Abramov, a Moscow-based associate at US law firm Coudert Brothers, who plans to speak at the Duma hearing, says Aksakov appears more inclined to find a compromise solution with Pleskachevsky to establish a qualified local country agreement for Russia under Isda guidelines, in a similar way to Germany or France.
Oleg Ivanov, expert secretary to the Duma’s credit organisations and financial institutions committee, says Russian and German civil legislation are much more similar than Russian and English law. “The Russian central bank tried to translate Isda master agreements in 1996 and 1997, but it was extremely difficult,” he says. “There is no strong definition between English and Russian law,” Ivanov adds.
But Ivanov is optimistic about derivatives legislation gaining momentum. “The government plans to write an amendment to the civil code by the end of the year,” he says. But even Ivanov concedes that Russian politicians – typically not familiar with derivatives instruments – view legislative changes for derivatives as a low priority compared with reforms linked to tax, housing, education and health. While, the government’s 2004-2008 reform strategy paper does include a section on derivatives, it is only about 30 words in a 50-page document. Ivanov, however, believes parliament may ratify new legislation next year.
His confidence centres on the support apparently being given to the initiative by Oleg Vyugin, the powerful head of Russia’s new super-regulator, the Federal Service on Financial Markets. Bankers also place much hope in Vyugin, citing his heavyweight political background as a former senior official in the Finance Ministry and deputy head of the Central Bank of Russia, as well as his commercial experience working as a chief economist at Troika Diologue, as ideal credentials to push forward market liberalisation. “He understand the importance of derivatives as an integral part of financial markets, and has stated openly that it is one of his priorities,” says Citigroup’s Shvedov.
But the final outcome is far from certain. Even if a first draft on new legislation does pass in the next six months, this is not a firm indication of the potential final drafting of new legislation. “For example, the new law on currency liberalisation appeared to be going one way, but the final outcome was somewhat different,” says Deutsche Bank’s Soloviev.
He is referring to the process promised by Russia’s President Vladimir Putin to have a fully convertible rouble by 2007. The early readings of the liberalisation rule implemented this year steered towards a simplified system of accounts, but the end result was a much more complicated system, with five different types of accounts and different reserve requirements and payments, compared with the previous S, N and K accounts.
“It means they are changing the rules of the game as we go,” says Soloviev. And Alfa Bank’s Vine says he has strong concerns about the potential geographic and sectoral segmentation of derivatives markets in Russia should the government press ahead with nothing fuller than a completely separate law for financial derivatives – something that now looks unlikely.
The implementation of new legislation is a critical factor for the development of an efficient and effective risk mitigation market in Russia – with netting and collateral representing two of the most critical concerns. It is currently impossible to net obligations on different contracts.
Under the current infrastructure, a dealer would be required to pay if its counterparty went bankrupt, but the counterparty’s offsetting contract would be placed in a general pool of claims. The situation is similar for collateral. “Even if you have a direct claim on onshore collateral, unless you move it onto your balance sheet, you have a problem if that counterparty defaults,” says Deutsche Bank’s Soloviev.
This issue has stifled the development of onshore securitisation. “For example, if you tried to collateralise credit card receivables and segregate the cashflows, if your counterparty defaults, that goes to the general pool of creditors,” says Soloviev.
“In my view Russia needs derivatives to make the markets more efficient and make the efficient allocation of capital deeper and more sustainable,” he adds. “But the derivatives environment in domestic Russia is still pretty much hostile.”
There is also a plethora of structural impediments in the Russian financial market that means even the successful introduction of robust derivatives legislation will fall short in creating a functioning derivatives market. Probably the most fundamental barrier is the inability to price up a domestic version of the world’s most frequently traded derivatives, interest rate swaps. The country does not even have a government benchmark curve.
Moscow bankers say there is no functioning repo market in Russia. Although the Central Bank and the Ministry of Finance are trying to build such a market, even if they are successful, there are still major issues. Despite some Russian government bonds having maturities out to 15 years, the underlying GKO curve has virtually stopped trading. The reason is the sheer scale of state-owned banks and state-backed pension plans in the marketplace.
“They consume such a large proportion of issuance they render the whole market untradable,” says a senior Moscow-based banker, who estimates state-owned enterprises account for at least 75% of the market. “If one player has full outstanding stock or front paper, they can lend it into the market and can take it back creating a massive squeeze,” he says. “So I cannot hedge my interest rate exposure in government securities.”
Foreign bankers in London have talked up Russia for some time. They say the market for offshore derivatives is booming – as are their profits. Meanwhile, bankers in Moscow are more cautious. They cite huge structural imperfections as not only hampering the development of an onshore market, but also hindering the creation of even the most primitive of instruments such as a rouble-denominated interest rate swap. They say urgent government action is required.
On close inspection, both parties appear to be right, which leaves the independent observer somewhat perplexed. And given the opaque nature of the Russian market and the uncertain direction of future developments, it’s probably the appropriate state to be in.
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