by Simon Pirani

Derivatives trading is reviving in Russia as the oil-based economic boom drives financial markets to new post-1998 heights. Alongside the embryonic domestic derivatives markets, structures giving foreign investors exposure to Russian equities and debt are proliferating. The main obstacle to development is the lack of a legal framework. However, parliamentarians hope to overcome this by pushing through a comprehensive derivatives law this year.

Russia's derivatives market is small but growing fast.Weekly futures volume on the derivatives division of the largest stock exchange (Futures & Options on the Russian Stock Exchange or FORTS) in late April was 3.4-3.8 billion roubles ($110-125m); weekly options volume was Rb60-80m. FORTS trades three- and six-month futures contracts in five of the largest corporate stocks. For the two shares on which futures are most widely traded, those of the gas monopoly Gazprom and the national power company UES, options are also available. The currency exchange, Micex, trades five equity-based cashsettled forwards contracts and dollar and euro forwards at much smaller volumes.

In mid-March, RTS, citing the need to provide more effective protection against sudden price movements, replaced cash-settled futures contracts in three equities (Surgutneftegaz, UES and Rostelekom) with deliverable futures contracts. Now only the exchange's index futures contract (S&P/RUIX) and its dollar-rouble forward contract are cash-settled.

Pavel Prosyankin, head of structured products at Troika investment company, the largest market participant, says: "It is not a broad market yet. It gives investors the opportunity to arbitrage between futures and spot markets. But the unsatisfactory legal framework is an obstacle to the development of a fully-fledged derivatives market."

Regarding commodity price hedging, the way is being led by St Petersburg stock exchange, an RTS affiliate. In January it launched a Urals oil futures contract; it also launched, but quickly withdrew due to lack of demand, futures on oil production tax and gas condensate. A Brent oil futures contract is also being prepared and some market participants are urging St Petersburg exchange, which took its derivatives business through the 1998 crisis without a single contract failing, to establish oil products, grain and sugar contracts. But market sources say that most of the contract’s volume, which for March totalled Rb229m, is accounted for by financial investors rather than industry hedgers.

Mikhail Bilinkis, director of derivatives at MDM Financial Group, explains: "Energy futures is still an undeveloped market in Russia. Most oil and oil products exporters don’t use derivatives to hedge oil price risk – firstly because there is an insufficient appreciation of the possibilities and secondly because of problems with tax legislation. Under current legislation it is possible, although not easy, to structure forward deals."

MDM Financial Group has developed dedicated OTC hedging structures, which are linked to listings on St Petersburg exchange, for crude oil, oil products, palladium, platinum and other commodities. Alfa Bank also offers similar products to traders. It is understood that the Russian airline Aeroflot has begun hedging jet fuel purchases through such structures.

While the flowering of derivatives markets is obstructed by the lack of a legal framework, the surging Russian economy – and especially the oil companies riding the crest of the wave – is providing the impetus for that framework to be put in place. A London-based banker with a long experience of Russian derivatives comments: "If one looks at derivatives as hedging rather than speculation, there are sizeable risks that cannot currently be hedged in the Russian market. As the leading Russian companies mature, they will want to hedge both their operations and their finances. The rouble is currently strong and for commodity exporters there is a need to hedge rouble-dollar risk. However, the Russian market is not big enough to provide the hedge; there's no big investor base to take the other side and there’s no legal certainty."

The statistics of the oil-led boom are impressive. In 2002, it produced $2bn worth of new Russian stock listings on foreign markets, four times the 2001 amount, of which 97.5% was oil or oil-linked paper; an exponential increase in the volume of Russian corporate eurobonds outstanding to $4.5bn, of which two-thirds was from oil and gas companies; a doubling of the domestic bond market’s volume to $4bn; and the biggest privatisation sale yet, of a state stake in the Russo-Belarussian oil producer Slavneft, which netted $1.7bn. This year more records were broken: in February, BP agreed to commit $6.5bn to a merger/takeover with the Russian oil company TNK, the largest slice of foreign direct investment by far; Gazprom issued the biggest ever emerging market eurobond, a $1.7bn ten-year issue that was several times oversubscribed; and, in April,Yukos and Sibneft announced plans to merge and create the world’s fourth-largest oil company.

And now the need for greater financial sophistication, above all by King Oil, is recognised by parliamentarians who have drafted a new Federal Law on Derivatives and are optimistic it could be passed this year.Two parliamentary committees, covering property and credit organisations and financial markets, earlier this year formed a working group with Russian banks including Alfa, Zenit and Trust & Investment, to consult on the law. PricewaterhouseCoopers (PwC) was retained as consultant and helped produce a draft. In mid-March, a delegation from International Swaps & Derivatives Assocation (Isda), headed by its ceo Robert Pickel, made an official visit to Moscow for the first time since 1998. The Association met with the parliamentary committees and agreed to provide comments on the draft. These will be completed shortly, following the meeting of its Central & Eastern European Committee that took place in mid-May.

Viktor Pleskachevsky, chairman of the parliamentary committee on property, says that the government, ministries and regulatory bodies were agreed on the substance of the law. "The atmosphere has changed. Since the new management [under governor Sergei Vasiliev] took over at the Central Bank,we hear them talking about using derivatives themselves for currency regulation. This was unimaginable a couple of years ago.We expect the law to go for its first reading in parliament during this month. There is no reason why it should not be passed by the end of this year." Although some market participants fear that parliamentary elections in December and the presidential poll next spring could disrupt the passage of the law, Pleskachevsky believes this is irrelevant to specialised legislation that has no impact on most citizens.

The ministries of finance and economic development and the Central Bank have approved the draft law but discussions are continuing on objections by the Federal Commission on the Securities Market, the main financial markets regulator. These concern not the substance of the law but the method of market regulation. At present, the Central Bank regulates currency derivatives, the Federal Commission regulates equity derivatives and the anti-monopoly ministry regulates commodity hedging instruments. Market participants believe that there should be a unified regulator, although they do not care which body takes on this role.

The largest legal cloud over the market that the draft law hopes to clear away is a decision by the Supreme Arbitration Court, made in the wake of the 1998 financial crisis during which a pyramid of poorly-regulated speculation on currency forwards by Russian and foreign banks collapsed, that nondeliverable forward (NDFs) contracts are unenforceable under Article 1062 of the Russian civil code that covers gaming and betting.

Parliamentary deputy Viktor Tarachev, also a member of the committee on credit organisations, proposes simply to amend the Russian civil code to make enforceable a range of derivatives including NDFs. The working group of market participants argues that such an approach tinkers with a framework that needs complete replacement. Anton Selivanovsky of PwC says: "The challenge was to adopt legal principles that have evolved internationally to the Russian environment. Copying them wholesale will not work, but neither will a piecemeal approach."

The working group has come up with four pieces of legislation:
A series of amendments to the civil code to make it fit with the new law
The Federal Law on Derivatives, which includes definitions of instruments designed for flexibility as new ones develop, principles of regulation and principles of government measures for crisis situations
A new law on netting
Reforms to the law on collateral for contracts.

Changes in tax legislation, now going through parliament, are also important for the derivatives market. Some market participants are concerned that, if the oil price falls and Russia's boom slows down before changes have been made, an important opportunity could be lost. Peter Werner, assistant director (European policy and legal affairs) at Isda, explains: "From our point of view, the issue is to achieve legal certainty, and to do it quickly."

On the other hand, progress on the law will open up a wealth of possibilities. Prosyankin of Troika says that the mortgage market would require asset-backed securities that will carry on what Troika and Bank of Moscow have recently started. They have created an instrument for the Moscow Mortgage Agency, guaranteed by the Moscow city government, the coupon on which is linked to the dollar-rouble exchange rate. Another project under discussion is the issue of Russian depositary receipts, modelled on ADRs, allowing Ukrainian, Kazakh and other CIS corporates to tap Russian financial markets.

Offshore structures

One section of the market not waiting for changes to the legal framework is that which offers investors offshore exposure to Russian markets, ranging from complex schemes to access the market in domestic Gazprom shares to credit-linked notes, which in the last year have begun to flourish alongside the mushrooming eurobond and domestic bond markets. "Grey" schemes accessing domestic Gazprom shares have been part of the picture since 1996, when a decree by then president Boris Yeltsin limited foreign ownership in the company, Russia's largest, to its New York-listed ADSs. Under the schemes - which respect the letter, if not the spirit, of the decree - Russian brokerages package instruments to offshore investors for which the underlying assets are the domesticallyquoted Gazprom shares. The investors are taking a bet that the government will implement the decision it has made in principle to remove the 'ring fence' between the ADSs and domestic shares, adding significantly to the latter's value. Up to 10% of Gazprom's $18bn market capitalisation is estimated to be held via the schemes. Brokerages active in the market include United Financial Group of Russia and Vostok Nafta of Sweden. A complicated registration scheme for foreign owners of shares in Sberbank, Russia's largest bank, has led to the development of similar instruments for them.

Russian investment houses also package wider exposure to domestic equity markets and Russian banks repackage and sell their credit portfolios.The growth of the domestic bond market in the last two years has been accompanied by the appearance of instruments that give foreign investors indirect exposure: direct
market participation requires a "N" rouble bank account in which funds must be kept for one year before repatriation. One market participant comments: "Investors in Russia have become used to high returns and, now these are harder to come by, they are looking for means to leverage up their exposure. Russian houses are offering OTC synthetic instruments, with both fixed income and equity components.We are only able to make this available to clients we know and trust."

An increasing number of euroclearable credit-linked notes (CLNs) are being arranged by both western and local banks for Russian companies that want to raise money on western markets that do not involve the complicated sales and regulatory processes involved with eurobonds. Although the market is not always transparent, it appears that Gazprom is the largest issuer. In May last year a $200m CLN was arranged for Gazprom by Depfa and West LB and a further Gazprom CLN was issued by Depfa this year. In addition, in January this year, ING Bank issued a $100m, one-year CLN with a 10.75% coupon linked to a loan to Sistema, the Moscow holding company that controls the telecoms provider MTS. And in November last year, Alfa Bank and Vneshtorgbank became the first Russian banks to arrange a CLN - a two-year $30m note with an 11.25% coupon, linked to a loan by ING Bank to the Urals-based machine builder United Heavy Machinery.

Liudmila Khrapchenko of Alfa Bank's fixed income department explains: "The notes are not really comparable to corporate eurobonds. Firstly, they are usually for much smaller amounts. Secondly, although they are euro-clearable, in practice they are not really liquid." Another market participant reports that the CLNs appear, like other Russian offshore instruments, attractive to Russian investors based abroad who are familiar with the companies comprising the underlying risk. Khrapchenko expects that mid-size Russian companies will continue to come to the market, although a source at another Russian bank says that CLNs would appear less and less attractive to issuers able to tap the ocean of liquidity in the rouble bond market.

Last but not least, the offshore rouble-dollar forward market - which perished domestically after the 1998 meltdown but has been reborn outside the country - is growing. Turnover is estimated by participants at between $10m and $30m per day, many times greater than a year ago but still short of its 1997 highs. CSFB, Deutsche and Dresdner are major players. When that show starts playing again in its home town, Moscow, you will know that Russia's derivatives markets have really come of age.

COPYRIGHT NOTICE: Reproduced from FOW magazine, June 2003. Metal Bulletin Plc 2003. All rights are reserved. No part of this publication (text, data or graphic) may be reproduced, stored in any data retrieval system, or transmitted, in any form whatsoever or by any means (electronic, mechanical, photocopying, recording or otherwise) without obtaining Metal Bulletin plc's prior written consent.