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One year ago, if a speculator wanted to take a position on eastern Europe, there were few options available. In the case of a western supplier wanting to hedge against non-payment from a state-owned buyer, options were non-existent.

All this has changed in past few months with the development of a variety of over-the-counter (OTC) structured products. Not only can structured products offer a convenient way to hedge investments, OTC products offer an alternative to Russia’s electronic custodial and settlement system.

The fastest-growing products so far have been those linked to Russian government paper. These are traded in London’s OTC market, traders are reluctant to reveal the size of their trading books. Equity-linked products also likely to take off in line with increased local trading in Moscow’s equity market where volumes have doubled from an average daily turnover of $30 million in March 1996 to over $60 million today. Although this volume is insignificant compared to turnover in the massive GKO, MinFin and Eurobond markets, derivatives could be the next big step for eastern Europe’s maturing capital markets.

The arrival of derivative products has had most impact on the sale of Russian government, rouble-denominated paper, GKOs. In the past the GKO market was hard to enter due to the bewildering array of restrictions (which distinguished between both foreigners and many domestic investors).

But since the rules were relaxed, GKO-linked instruments have become among the most common derivative products. And investors can increasingly choose products structured to suit their needs. One instrument pays the holder a dollar-based return which is indexed to the underlying rouble market. As long as the GKO pays out, the holder is guaranteed a dollar-denominated return. The investor no longer needs to worry about the rouble corridor, conversion risk or unclear regulations on foreign participation. Another structured product pays investors a Deutschmark return on six-month to two-year MinFin paper.

The most interesting play now being marketed is a package combining a currency convertibility product with a credit default derivative. With a default product, the buyer pays a premium to insure himself against non-payment from a benchmark instrument. Should the benchmark instrument default, the holder of the derivative has the right to sell the bond for a predetermined amount.

Typically a pay-out is made calculated on the bond’s historic cost less its residual value. The word insurance is assiduously avoided since most western jurisdictions have substantial prohibitions in place against banks writing insurance contracts.

To insure the $100 face value of a five-year Russian Eurobond against default, a bank will typically ask for 200 basis points to issue a one-year put at a $100 strike price. Say Russian Eurobonds are yielding 340 basis points (bp) over US treasuries, the default-protected yield would be only 140bp above.

An investor buying the put may not even be interested in holding the Euro. Instead, he could be in the market for some downside protection for a government-linked project finance deal or loan syndication.

Credit and convertibility products may seem most useful to corporates selling to state-owned firms in return for soft currency, but, in fact, commercial banks are the most enthusiastic buyers so far. If a lender is holding non-liquid loans on its books (typically to large state-owned firms) it may want to extend the credit line to its existing clients or even find new untapped borrowers.

Risk management guidelines, especially in view of the new Capital Adequacy Directive (CAD) from Brussels, will restrict any new unhedged lending. Purchasing a credit product may eat into profits, but it permits the bank to extend further credit and keep within its risk parameters.

“I don’t think that credit derivatives have really taken off in any of these markets as yet,” says Rob Reoch, head of credit derivatives at Nomura International, “although there are a lot of enquiries.” Reoch explains that it is still a largely illiquid market: “At times, there are a lot of buyers but no sellers.”

Although a few houses consistently quote two-way prices on credit options, they are typically linked to more stable markets, such as the Czech Republic or Hungary. But Reoch believes this will change. “As more and more banks focus on their strategic plans for business in eastern Europe, they will look on credit derivatives as a way to manage risks and hedge out illiquid credits.”

The market for east European currency and credit-linked derivatives has the potential to reach Latin levels of volume. But, before this can happen, capital inflows to emerging market corporates must increase, and more importantly International Swaps and Derivatives Association documentation must be standardized.

Many commonly-used terms in customized documentation are open to interpretation. For instance, when the Russian ministry of finance froze some of its outstanding MinFin bonds, suspecting that they had been stolen, they argued that this did not amount to default. But holders of those bonds were not paid interest and some believe this is the clearest definition of default.

The array of traded and listed products available, combined with less-than-perfect information and volatile underlying markets, creates the potential for arbitrage trading.

“I know there are some arbs looking around the markets, but liquidity is just not good enough for significant arbitrage activity,” says Max Alexandrias, vice president for structured products at JP Morgan in London. Alexandrias thinks the most promising development will be in the area of offering vanilla swaps on local interest rates ­ for instance, Polish zloty floating-rate instruments for fixed-rate.

There is also massive potential to be tapped in targeting derivative products at east European domestic users. Until recently it was assumed that capital was predominantly sourced from G7-countries, since local investors did not exist. But recent trading in Russia has questioned this. “There were several days in January and February when virtually all buying of Russian securities was coming from domestic investors and virtually nothing from foreign institutions,” says Maxim Shashenkov, Russia analyst at Merrill Lynch. “This is in complete contrast to last year when foreign trading consistently accounted for almost all the volume in the market.”

While the OTC derivatives industry is growing fast, however, trading is slow on eastern European derivative exchanges in Budapest, Moscow and St Petersburg. Market participants were almost completely unmoved, for instance, when the St Petersburg Futures Exchange (SPFE) recently announced the introduction of three new contracts on wheat, petrol and timber.

The aim of the new contracts is to attract project financiers and direct investors involved in commodities-related industries. The SPFE already trades several contracts relating to currency and debt, including Russian government instruments. But the ad fact is that after three years of operation the SPFE manages an average daily turnover of only Rb30 billion roubles ($5 million), about the value of one minimum ticket deal done by a single trader in any of a dozen London houses.

Determined not to be left behind, the SPFE plans to use the internet to expand trading. Already, the SPFE website (www.futures.ru) provides a wealth of information, including prices on the last contract exchanged and overall volumes. Should the internet project take off, a foreign institution owning a seat on the SPFE could, in theory, execute, clear and settle an unlimited number of trades entirely through an internet account without ever having an actual presence in the city. All very impressive, but foreign institutions, which are crucial to its development, are largely ignorant of the existence of the SPFE or the region’s other derivatives exchanges.

“I still think it is too early for any local derivative exchanges to take off,” says Constantinos Grigiriafdis, head market analyst for central and eastern Europe at the IFC. “There has to be good liquidity throughout all the local capital markets, not just a handful of blue-chip shares and state bonds, as is the case at present.”

Despite this, Grigiriafdis believes it is only matter of time before broadly-based, listed derivatives begin to develop.

Nomura’s Reoch is optimistic about the future of the east European derivatives industry as a whole. “The common denominator in all of these areas is that, where there is a developed cash market, there is also the potential for a derivatives business to develop one step behind.”