Opening up custody
Planned merger of Russia's rival exchanges could clear the way for securities lending, writes Iain Morse
Russia's rival exchanges are set to merge, a move which could transform the nation's
custody industry. Micex, the Moscow Interbank Currency Exchange and RTA, the Russian Trading System, are separate, vertically integrated silos. "Each has its own settlement depositary," explains Maria Ivanova, head of direct security services at Deutsche Bank in Russia, "Micex has the National Settlement Depositary (NSD); RTS has the Depositary Clearing Company (DCC)."
"The order to merge is part of a wider strategy to make Moscow a global financial centre, a strategy enunciated a couple of years ago by Vladimir Putin," says Tim Reucroft, a director at Thomas Murray. If Moscow fails in this large ambition, repatriating a fraction of the huge sums of Russian capital that emigrated to Cyprus, London and Switzerland over the last two decades might suffice. "This business keep growing and non-Russian foreign investors are very interested," adds Göran Fors, head of global transaction services at SEB Bank.
Micex is one-third state owned, and the ministry of finance has already declared an intention to sell off this stake once the merger is completed - as always, the Kremlin is ubiquitous in the economy's commanding heights. Whether this sale ever takes place, Alexander Voloshin, the director of the working group on Moscow's status as a financial centre, has recently made it clear that the new MICEX/RTS exchange will not merge with any foreign ones.
Settlement in Russia is a complex, sometimes risky and always costly process, usually characterised as ‘two-leg' - separating transfer of title from transfer of purchase monies. Currency is also an issue. "The cash side of settlement is typically in dollars not roubles; the dollar effectively functions as a reserve currency for local share settlement," says Vasily Permyakov, head of security services sales at ING Bank. Current settlement practice falls either into ‘deliver versus payment' (DVP) or ‘free of payment' (FOP). Securities kept with the Depositary Clearing Company (DCC) can be settled over the counter (OTC) with DVP, with cash settlement in dollars via JP Morgan or the RTS Settlement function.
When securities are kept with the NSD, settlement of OTC transactions can be made on a FOP or DVP basis, with the cash side in either roubles, dollars or another currency. DVP settlement has its benefits; trade settlement dates can be set between parties, and fees are flat, rather than a percentage of deal size. Both parties manage the cash side by using the same settlement bank for transfers. The NSD can transfer securities internally between client accounts, or between third parties, whether other depositaries or registrars.
FOP appears to be the most common route for settlement because of its lower cost and other factors, such as tax treatment - both on and offshore. But the key to FOP is managing counterparty risk and this risk is sufficient to discourage many foreign investors from going to Russia. This helps account for the number of Russian companies listed abroad and the use of GDRs and ADRs for Russian MICEX/RTS companies on exchanges like the London Stock Exchange.
The role of the registrars also needs to be taken into account. There are 44 of these, with offices scattered across the Russian Federation; changes of ownership in shares must be registered in person at the relevant office. Some of Russia's largest firms are registered in Siberian offices. Shareholders meetings may also be held in these distant places - a fact exploited in the past by the unscrupulous when some shareholders found their access to meetings barred. Structural renovation of the entire system to meet international standards of practice will supersede the registrars but they have lobbied against change.
This sense of covert interests and conflict is also evident among non-domestic investors. As much as 80% of daily trading in equities listed on MICEX/RTS is attributed to them. "The equity market is worth $1trn (€684bn), but local institutional investors only own $30-35bn of this," believes Alexei Fedotov, director and head of securities and fund services for CIS at Citibank. "The market is shaped by offshore investors." But most of this money is believed to originate in Russia, exported, then re-invested from offshore entities, many domiciled in Cyprus under the ultimate control of small syndicates of oligarchs.
The role of non-domestic investors also explains the current configuration of the custody industry in Russia. Deutsche, Citi, SEB Bank, Unicredit, ING and others have offices in Moscow and St Petersburg. They have recruited and trained high quality Russian staff. These multi-country local custodians are all committed to building their market shares in the CEE region but most do little or no business with onshore domestic Russian clients. "These offshore investors want to minimise the operational and counterparty risks of this market and they feel comfortable using non-Russian custodians," says Fedotov.
State-owned and controlled banks like Sberbank and, notably, VTB Bank are also in the Russian sub-custody market, seeking to expand market share. Both banks would like to make acquisitions outside Russia but their ownership will hinder this ambition. It is certain that their commitment to the domestic custody business is influenced by Putin's plan for Moscow's development as a financial centre.
The merger of Micex and RTS opens the way for the creation of a single central securities depository (CSD) in Russia, eliminating much of the risk in the current registrars systems, hugely reducing direct settlement labour costs and the settlement period. Other changes needed include the introduction of foreign nominee or omnibus account structures. At present, foreign custodians in Russia are regarded as the beneficial owners of equities they hold on behalf of remote foreign clients. "We need foreign nominee accounts here," adds Fedotov. "The advent of nominee accounts comparable to those in the US or UK would resolve a lot of issues."
This, in turn, would open the way for securities lending in Russia which at present does not properly exist. In fact, there is no clear legal framework for lending, although Ivanova points out that there is a repo market. A repo is an agreement for the cash sale of securities followed by their repurchase at a fixed price - similar to borrowing at a fixed rate of interest. Securities lending, by contrast, can be effected with collateral in cash or securities.
The current practice of settling offshore in dollars would also be superseded by onshore, rouble-denominated settlement if a capable CSD is set up after the exchange merger. "This would create a demand for the management of currency risk as offshore investors convert their currencies to roubles," adds Fors. Some investing institutions manage this in-house but it is probable that many would rely on their custodians to do so.
"If these changes are made there will be consolidation but also growth in the Russian custody market," adds Parmyakov. "Costs and risk will be reduced, to the ultimate benefit of all investors."