Iain Morse finds that the creation of a single, mandatory central settlement depositary later this year will have wide-ranging effects on the trading and settlement of securities in Russia
Change is afoot in Russia. In principle, its stock and bond markets have been among the most open of the BRIC countries but the reality is far less clear. Settlement, and post-trade infrastructure have been costly, complex, and expensive - sufficiently so to deter all but the most determined foreign investors from direct investment.
In line with Russian president-elect Vladimir Putin’s stated ambition to make Moscow into a financial centre rivalling London and New York, last December his predecessor president Dmitry Medvedev signed off two laws, Law No.414-FZ (the Law on Central Securities Depositary) and Law 415-FZ (the Law on Amendments to Laws on Securities Markets). These will take effect at the end of 2012, renovating post-trade infrastructure and settlement, enhancing liquidity, and improving access for foreign investors.
The key reform enacted in these laws will be the creation of a single, mandatory central settlement depositary (CSD) due to be in operation by August this year. From this, much else will flow - not least, the creation of nominee accounts for foreign investors. “The law 414 gives a full legal definition to the CSD,” observes Alexei Fedotov, head of securities and fund services at Citi for Russia and the CIS. “Once set up, it will meet international standards for the same.” Specifically, its design is intended to satisfy the requirements of SEC Rule 17f-7.
The current infrastructure came into being in the 1990s as a result of mass privatisation of state enterprises by the issuance of negotiable vouchers which could be sold or exchanged for shares in the relevant, post-privatisation enterprises.
Some useful measures were taken in a first wave of reforms; share certificates were electronic not paper. But little thought was given to infrastructure requirements for trading in volume or the establishment of a central depositary. Instead, share registrars were given responsibility for maintaining accurate lists of shareholders, and ensuring title changes when sales take place.
More than 500 were set up across Russia’s 11 time zones. Shares were electronic, but transfer and settlement were paper-based, requiring physical delivery of transfer orders to share registrars. “Fees were as high as 70 basis points of transaction value, but the massive profits made on share prices distracted investor attention from this,” adds Fedotov. Needless to say, it also gave the registrars reason to obstruct change, in a long campaign of lobbying lubricated by cash. Nor do major domestic investors, particularly oligarchs, necessarily welcome foreign investors and their money. Why would they?
Russia’s first national stock exchange was the dollar-denominated RTS, based on NASDAQ systems. In 1998, the Depositary Clearing Company (DCC) became its settlement depositary as an alternative to the registrar-based settlement system. Subsequently, the RTS would oblige broker members to use the DCC, desisting from the physical transfer of orders. However, foreign investors continued to use registrars. Russia’s second exchange, the rouble-denominated Moscow Interbank Currency Exchange (MICEX), operated its own National Depositary Centre (NDC).
Settlement was effected in this new depositary via SWIFT or proprietary systems, removing the need to use registrars for transfer. Fees fell as a result. In both RTS and MICEX, the adoption of these new practices was driven by the exchanges and brokers but were not mandatory. Hearsay suggests that syndicates of private investors sometimes still preferred to use registrars to increase the opacity around their deal making.
For foreign investors use of a registrar remained a legal requirement, while use of a depositary was not. “This made many cautious about the use of settlement depositaries, not least due to a lack of clear recourse if the depositaries fail,” adds Fedotov. A crucial issue for many foreign investors was the lack of a single mandatory Central Securities Depositary compliant with the SEC Rules 171-7. The absence of a mandatory CSD meant that some types of US investors, including pension funds, were not permitted to use the Russian depositaries due to domestic US regulations.
The use of settlement depositaries by Russian brokers and investors increased sharply after 2005, as the market became much more liquid following some major IPOs and the relaxation of rules on ownership of bank shares. The number of registrars shrank rapidly to 41 by 2011 due to merger and acquisition, but this did not entail much greater efficiency. The two settlement depositaries won market share. But fees, settlement cycles, and communication and software systems were still far from being standardised. The use of the rouble in one exchange and the dollar in the other, widespread use of GDRs listed in London, their American equivalent, listings in Tel Aviv and Hong Kong, all helped to sustain inefficiencies.
The intention is that over 7,000 listed Russian equities, including micro-caps, and all exchange-traded bonds will settle via the CSD. Only a tiny, economically unimportant fraction of the market will be settled outside the CSD. This has a variety of consequences. Most obviously, a single settlement cycle is likely to emerge as is the case elsewhere. Brokers and dealers will enjoy cost benefits as the CSD will use a single set of programmes and systems. Cost savings will result.
Other less obvious consequences will have a major impact on listed companies in Russia. Under the registrar system, for instance, registrars and all foreign entities, including global custodians (GCs), and brokers, were treated as ultimate beneficial owners under Russian law. This meant that shares attributed to a single entity like a GC had to vote in unison; their vote could not be split. Once a CSD is established, this will cease to be the case. And if shareholders using the same registrar took an aggregate of more than 25% of the shares issued by a company they had to apply to the monopolies commission. The overall consequence of these changes should be to improve governance within listed companies as they facilitate shareholder activism.
As mentioned, the CSD will permit the use of nominee accounts identical or similar to those used elsewhere. Many of the global custodians already have de facto segregated accounts with registrars. “There are still details to be decided here,” warns Fedotov. The most important of these is whether client identities will need to be disclosed. This could prove unwelcome to the many ‘offshore’ Russians who keep their money in Cyprus but invest in Russia. Whether disclosure is obligatory will also be important for depositary-receipt banks of which there are over 100 in Russia issuing ADRs. ADR holders who do not disclose might lose their voting rights and dividends. Last, but not least, the CSD will open the way for ICSDs such as Clearstream to open nominee accounts in Russia. As currently conceived, ICSDs will be required to apply for permission from the Russian regulator for permission to open such an account.
See page 14 for more on Russia