Iain Morse explains why the former member of the Soviet bloc has such a complicated system and why it is difficult to change
Does one country need 10 stock exchanges? Ukraine has this many, not to mention over 300 licensed local custodians. “Exchange consolidation is a logical step which should be made,” says Larisa Lapina, head of custody at SEB Bank. Needless to say, much settlement and custody remains over-the-counter (OTC), paper-based and manual. But this is due for change.
Ukraine’s financial infrastructure is still closely linked to that of the Russia. Of Ukraine’s 10 exchanges, the First Securities Trading System (PFTS) and the Ukrainian Exchange (UX) jointly have around 90% of daily trading value in domestic equities and bonds.
Both are partly owned and under the primary control of, respectively, the Russian MICEX and RTS stock exchanges. These are due to merge in the Russian Federation. “There may be a short delay after this but we expect the same to take place with their subsidiaries in the Ukraine,” says Alexei Fedotov, head of custody at Citibank.
MICEX owns 51% of PFTS, a private company, RTS 40% of UX, a listed company. PFTS has the larger market capitalisation, currently around $140bn (€102bn) and a far higher daily trading turnover than the UX, which has a market cap of around $40bn. Some shares are listed on both main exchanges, some not.
Even where shares are listed on both, their daily trading volumes per exchange may differ widely. During 2010, PFTS’s most actively traded equities included Stitol and Raiffeisen Bank Aval. Those most actively traded on the UX included Centerenergo, and Alchevsk Metallurgical Plant. Both traded high volumes of Ukrnafta and Ukrsotsbank.
The All-Ukrainian Securities Depository (AUSD) is the country’s main depository for the equity and bond markets, formed by merger in 2009. The AUSD is jointly owned by members including the National Bank of the Ukraine, PFTS,UX, 48 Ukrainian custody banks including subsidiaries of foreign banks and non-bank custodians such as local broker-dealers.
Under Ukrainian law, security trading is carried out through registered local broker-dealers. Exchange trades can also be carried out offshore via an offshore broker but this might trigger withholding taxes on income. OTC trades are effected via the AUSD on a DF or DVP basis; the AUSD is responsible for the exchange of cash and securities.
“There are many similarities to Russia,” says Fedotov. The large number of licensed custodians includes locally licensed broker-dealers, which automatically acquire custodian status as part of their licence. Share registrars, facing extinction due to the de-materialisation of the Ukrainian stock market, have also been given custodian status.
This is similar to the position of registrars in Russia. “There is no official data on the market share of custodians,” warns Fedotov. “However, it is clear that for many entities licensed as custodians this business is insignificant.” Many do not consider custody as a core activity, offering the barest of plain vanilla service to clients.
All the evidence suggests that foreign investors prefer dealing with custodians and sub-custodians that they first encounter outside the Ukraine: Citi, SEB, ING, and Credit Agricole Corporate & Investment Bank are all present in Kiev and await the opportunities that will flow from market rationalisation.
One reason why so many local custodians persist is that the Ukraine, like Russia, does not permit omnibus accounts; each ultimately beneficial holder must be disclosed. According to the 2010 Annual Report from the Ukrainian State Securities and Stock Market Commission, there were no fewer than 2.9m individual accounts of which the majority - 97.7% - are in the names of Ukrainian residents, and many of the remainder are for resident corporate entities including investment and pension funds.
Impediments to foreign investment include currency controls, although these were substantially relaxed in March this year. These changes reflect the dematerialisation of settlement and custody; previous requirements to tie paper transaction records with currency exchanges arising from the sale and purchase of equities and bonds have been abolished.
Account controls on all forex transfers in and out of the hryvnia have been removed or streamlined in a manner that should make investment less daunting than previously was the case. “The easing of currency controls will make it far easier for foreign investors to come here,” affirms Fedotov. Nevertheless, currency risk will remain an issue for foreign investors; the hryvnia is not pegged to any larger currency and domestic inflation is currently around 18% per annum.
If the anticipated merger of the PFTS and the UX materialises, this should lead to further rationalisation in the settlement and custody processes but, at present, most foreign and domestic investors still settle OTC - estimated to account for around 90% of all settlement. However, on exchange settlement, rates are growing rapidly from a low base, doubling from just 4.5% at end 2009.
OTC is almost always used by non-resident investors as a means of mitigating tax. Tax rules are complex, despite a basic rate of tax of only 15%, and offshore investors residing in Cyprus pay 0% tax if their deals are OTC. In addition, exchange trades require pre-funding, while OTC does not.
As in Russia, OTC settlement is a two-leg process. The parties to each transaction sign a sale/purchase contract via a local Ukrainian broker-dealer. OTC settlement requires each party to then instruct their respective custodians to deliver/receive securities; the delivering custodian initiates the transaction and the receiving custodian accepts it based on the original sale/purchase agreement. The US dollar functions as the reserve currency and is typically used in OTC transactions with payment taking place offshore.
Ukraine sits uneasily between the EU and Russian Federation. Exchange merger there will increase Russian influence in Kiev and provide a far deeper pool of liquidity than presently available. The Ukrainian exchanges and capital markets are competing with exchanges like Warsaw, which has provided a venue for initial public offerings by Ukrainian companies.
One of the latest, Geo-Alliance, an oil company owned by the high profile Ukrainian billionaire Victor Pinchuk, is currently raising $258m via Warsaw. More are in the pipeline. “There is a lot to play for and if the Ukraine can adopt best practice, the reward will be considerable,” adds Fedotov.