Russian system is on borrowed time

Financial News

Jason Corcoran in Moscow

16 June 2008

The Russian securities market has attracted substantial inflows from western investors in the past few years but the infrastructure to support the growth is only slowly catching up.

The average daily volume of transactions of Russian stocks stands at $6.1bn (€3.9bn), which includes $5bn traded on domestic stock exchanges with the remainder traded on foreign exchanges, according to investment bank Troika Dialog.

Investors have recognised some improvements over the past few years, but still regard dealing in Russian securities as a transaction, settlement and custody risk.

Most Russian investment offerings to non-Russian investors are domiciled in the Cayman Islands or in Guernsey, and often administered in Ireland. Global custodian State Street administers Prosperity Capital and Hermitage Capital, the two largest equity funds investing into Russia, from Dublin.

Damian McEvoy, associate vice-president at State Street’s subsidiary Investors Trust Europe, said: “Any initial scepticism about investing in such funds is unfounded, as all investors must go through rigorous anti-money laundering checks before being allowed to subscribe to these funds.

“But clearing and settlement standards have some way to go before reaching international benchmarks. Investors in Russian securities are typically only permitted to redeem on a monthly basis, and can sometimes have their redemption payments delayed due to the corresponding delay in the settlement of the underlying security sales.”

Hedge fund Hermitage, which has scaled down its activities in Moscow, has experienced considerable delays in the transfer of funds within Russia, the conversion of roubles into other currencies and the remittance of monies outside of Russia.

It said: “Delays may occur in the collection of dividends, proceeds of sales, redemption monies and other cash sums, possibly causing currency exchange loss, and some monies may not be received. In addition, due to the local postal and banking systems, it cannot be guaranteed that all entitlements attached to securities acquired by the fund, including in relation to dividends, can be realised.”

Most custodians point to the lack of a central depository, the numerous registrars and the need to register securities physically as the market’s most glaring inefficiencies.

Ramy Bourgi, head of emerging markets development at Société Générale Securities Services, said: “There is a record of the system working since the 1998 crash but it is not the most efficient from an operational point of view. It would benefit from a central depository and if there were not as many as 76 registrars.”

Legislation proposed by the Russian regulator two years ago to create a central depository was never passed in Russia’s parliament. Industry sources said settlement services provider Euroclear was approached by the regulator to be an adviser and create such a depository but that a final contract was never signed.

Stephen Cohen, chief executive of Troika Dialog’s hedge fund business, said: “It is a creaking system. Settlement can suffer from long delays when you use local registrars and their custody costs can be higher than in other markets.”

Troika’s $150m Cayman-registered Russian hedge fund uses Deutsche Bank as a prime broker and Deutsche Bank uses a network of sub-custodians in Russia.

A large amount of trading in Russian shares still occurs outside the country – in US or global depositary receipts with settlement in US dollars – but Russia is moving to repatriate this activity. That would require greater direct foreign investment in Russian equities, which has been erratic due to poor infrastructure and investor sentiment.

Some custodians, such as Northern Trust, have so far opted to steer clear of Russia because of the high proportion of captive non-state pension funds.

A Northern Trust spokeswoman said: “Russia is not a country in which we are really involved, and neither are we looking at it at the moment. There are apparently few pension fund assets in Russia. As serving pension funds – asset management and asset servicing – is one of the main parts of our business, there are fewer opportunities for Northern Trust. The main asset owners in Russia are the banks, and it is not a sector we are chasing at the moment.”

Acquisition of Russian banks by foreign organisations is seen increasingly as important for entering the competitive domestic custody market.

UniCredit is a leading sub-custodian in the Russian market through its ownership of International Moscow Bank, which was acquired by the Italian group’s Bank Austria Creditanstalt subsidiary in January 2007.

UniCredit, which also acquired Russian brokerage Aton Capital last year, sees Citigroup and ING as its main rivals.

Meanwhile Société Générale is hoping that increasing its stake in local bank Rosbank to 50% this year will allow it to become one of the dominant participants in domestic investor services and business coming in and out of Russia. The French bank paid $1.7bn for a 30% share of Rosbank, in addition to the 20% it already owns.

Bourgi said: “Russia is our top priority for Eastern Europe and Rosbank has a good domestic client base with $25bn in assets. Our job is to work with Rosbank to raise services to international standards and to serve existing clients.”

Bourgi, who joined SG in September last year with a mandate to develop the bank’s capability in emerging markets, said global custodians need a presence on the ground with local expertise.

“You cannot offer direct custody without being in the market. We go where clients want to go and Russia is an up-and-coming market,” he said.

Rosbank’s clients include many high-profile corporates that are beginning to branch out in international markets.

Consequently, Bourgi believes the domestic market is as attractive as the in-bound investor segment, if not more. He said: “When our Russian clients go international we will be able to capture their out-bound fund administration and custody needs.”

Information service Lipper Feri’s figures show that investments by European equity funds investing in the CEE – defined as Russia, Eastern Europe, the Baltic states and Turkey – rose from €5.3bn ($8.4bn) in 2002 to €38.6bn in July 2007. Much of that spurt is attributed to the growing interest in Russia.

While aspects of Russia’s capital markets have developed apace, its infrastructure is clearly lagging.