The creation of a CSD is a key pillar in Russia’s revamped financial architecture that aims to open up vast new pools of capital to Russia’s bond market. All the documentation to create a CSD was submitted to the financial regulator Federal Service for Financial Markets (FSFM) last week, and Astanin – who will head up the new institution – says he sees no problem for it to be accepted on time this week.
Custodians are the engineers of the financial world: the slightly geeky number crunchers who actually take care of the shares and bonds that traders buy and sell, recording the change of ownership and making sure everyone gets paid promptly in the deal. It is not the most exciting part of investment banking, but like engineers in the real world they are the ones who build the suspension bridges, towering skyscrapers and motorways that can transform an economy. And that is the hope: the creation of a long-mooted Russian CSD will hook Russia’s capital markets into the global system and allow traders and institutional investors around the world to buy and sell assets listed in Moscow from the comfort of their trading desks anywhere in the world.
The Russian Ministry of Finance has already tested the waters by selling one of its sovereign bonds, the so-called OFZ, through the CSD in February using the over-the-counter (OTC) trading system. The CSD for OTC trades has existed since the start of the year, but the documents sent last week will provide the basis for it to cope with exchange-based trading. The dry run in February was very successful, raising hundreds of millions of dollars and the issue was two-times oversubscribed. "But the real international demand from the international community will come when investors can come to Russia to buy government and corporate bonds directly on the Russian exchange," says Astanin.
The CSD makes international trading a lot easier, but the main goal is to tap into new pools of capital: the new Russian CSD has been specifically designed to meet all the US Securities & Exchange Commission's rules and regulations. The lack of a CSD prevented the world’s largest funds from investing in Russian securities due to restrictions imposed by domestic prudential regulations in places like the US. "If international institutional investors and pension funds come to Russia and invest, then it will have a positive affect on the pool of investors for potential IPOs of Russian and other issuers on the Moscow exchanges," says Astanin.
Astanin goes on to point out that the state too has a vested interest in deepening the pool of investment capital given its ambitious privatisation programme: the government said in September that it hopes to raise RUB223bn ($7.2bn) this year and another RUB2.598 trillion ($83.8bn) of assets is in the preparation stages for sale. In all, it wants to sell RUB3.1 trillion ($100bn) of assets by 2017 – much of it through the stock exchange.
While opening the doors wide to international capital will clearly bring Russia some fresh capital, no one is quiet sure exactly how much will arrive. Astanin believes a fresh $30bn to $40bn will be invested over the first year or so; others like VTB Capital predict a far more optimistic $50bn in just the first few months, due to a rebalancing of Russia’s indices.
The bottom line is that current foreign investors account for about 4-5% of government and corporate bonds outstanding, well below the 35-40% that foreigners held of the Yeltsin-era GKO sovereign bonds (the precursor to the OFZ) and less than the 15-20% held by foreigners in the bond markets of Russia’s BRICS peers.
Still, opening the door to capital also comes with a danger: money can flow out of Russia just as easily as it flows in. With capital flight of $85bn in 2011 and an estimated $65bn due to leave this year, the government has decided to delay adding equities to the CSD system until 2014, although it would be possible to include them from day one.
All Russia’s bonds are already registered in the CSD system and so trading can start immediately, but the state wants to run the system for nearly two years before making a decision on hooking up the equity market as well. Besides, integrating the bonds will be simpler than equities, which need a little more infrastructure work.
Until now, Russia has had two main depositories that hold all the bonds and shares: the National Settlement Depository (NSD) is owned by the central bank and traditionally has handled all the bond trading business; the Depository and Clearing Company (DCC) was owned by the leading equity market participants and traditionally has dealt with the equity side of the business.
The NSD has been nominated to take over as the CSD. The DCC will be later integrated into the NSD platform and to play the function of a trade depository; its role become to track all the over-the-counter trading so the regulator can keep tabs on what is happening in the market outside of the formal trading on the exchange. "We have to move DCC services to the NSD platform and that will take until the end of the year. It will record all the OTC trades, swaps, options, derivatives and so on, so the regulator has a tool to monitor what is going on in the market,” says Astanin.
While the NSD is ready to handle bond trading from day one, the DCC system still needs to be incorporated into the NSD platform. The two systems also traded with each other so a bridge between them already exists and integrating them is pretty easy. "Euroclear says it is ready to handle the trading of equities from December, but the plan is to include equities from about 2014," says Astanin. "There is a threat of extracting liquidity from the local market that could flow out of Russia. The government want to watch what happens on the bond market first before making a decision on including equities."
The last piece of the jigsaw to make the new system work is to create the so-called "foreign nominee" accounts.
The way depositories work is to have a book in which they write down who owns each share. The advantage of a central depository is there is only one book that lists all the assets and so reduces the risks that something gets lost. However, constantly changing the names in the register is time consuming and expensive, so most of the custodians that work with the traders hold the shares under their control in nominee accounts, and these accounts are in turn registered with the central depository. The advantage is if you trade heavily with the same people, then you can do your own in-house temporary accounting faster and cheaper, only settling up with the CSD periodically when there are more permanent changes of ownership.
Nominee accounts is the bean-counting bookkeeping part of trading, but in Russia the lack of a law to allow nominee accounts until now has exposed foreign investors to the risks of losing their entire investment. As Russian law didn't recognise foreign nominee accounts until now, the custodian who actually held the stock was deemed to also be the beneficial owner of the shares: the actual investor who paid for them had no right to claim them back from his custody. In effect, billions of dollars of investment into Russian equities are secured by nothing more than a promise by the custodian to hand over the shares if the investor wants them back.
The danger of this arrangement was highlighted in 1999 in the wake of the Bank of New York money-laundering scandal when Natasha Kagalovsky, a Russian-born senior vice president who ran the bank's Eastern European division, sued Russia’s biggest custodian for damages and laid a claim to the shares the custodian held – shares that actually belonged to other people. Happily she was persuaded to drop the case, but it gave investors into Russian equities a nasty jolt at the time. "The NSD will open foreign nominee accounts in the CSD. It will take another month for the IT connections to be put in place that will connect us to the international trading systems, but after that we will be in action," says Astanin.
Setting up nominee accounts is the technical part of finalizing the arrangement with the main international settlement and clearing systems Euroclear and Clearstream, which are otherwise ready to start work, says Astanin.
With Russia's budget expected to regularly go into deficit in the years to come, the financial market reforms are designed to make it easier for the government to borrow abroad, and to deepen the pool of capital to enable both state and private domestic IPOs, while aiding a nascent pension fund business that needs a bigger, more stable capital market if it is to return enough to look after Russians in their old age.
However, the government is also hoping to make Moscow a regional financial capital that all the countries of the Commonwealth of Independent States (CIS) will use to raise and invest capital. Astanin says that he has already been touch with the authroities in other countries of the CIS, which are watching his progress keenly. "We want to build a regional hub of liquidity for companies in the CIS,” says Astanin. "We will use our network of international investors to buy and sell equities and bonds from Ukraine, Belarus, Kazakhstan and other countries."
Ben Aris in Moscow