Pressure on the system

A SUPPLEMENT TO EUROMONEY – APRIL 1997

Russia’s equity market is opening up to a wider range of investors as an infrastructure emerges for its once shaky stock market.

A year ago the market was dominated by New York-based hedge funds, dedicated Russia funds and high-net-worth individuals. Now, a variety of US pension funds, emerging-market mutual funds and index funds, European and US insurance companies, wealthy retirees and Russians are entering for the first time. Trading volumes have doubled, and share prices were up more than 60% in dollar terms in the first quarter of this year after a 130% gain last year.

The arrival of new capital reflects recent improvements to the securities market infrastructure: share trading is more efficient, the securities commission has ministry status, there is a better legal framework, more protection of shareholder rights, and custody and registry services have been expanded. Depository receipts and other derivative products have helped a wide range of regulated institutional investors acquire a taste for Russian equity.

“The new investors in Russia are of the buy-and-hold variety,” says Vladimir Bril, head of Russian equity sales in New York for the Scandinavian investment firm Alfred Berg. “We’re now witnessing emerging-markets funds and international and global funds moving in. Within 18 months, I predict that Russia will be a part of most every international portfolio.”

The approval of several local subcustodians removed the largest barrier to investment in Russia by the US regulated investment funds, which command vast capital. The US Securities and Exchange Commission (SEC) now allows Chase Manhattan, Credit Suisse and ABN Amro and the Russian bank Oneximbank to offer subcustody in Russia to US regulated mutual funds as “eligible custodians” by meeting the requirement of having foreign parent companies with more than $200 million in shareholders’ equity. While UK investment funds are not formally bound by such regulations, their compliance officers usually impose similar requirements.

As local custodians such as Credit Suisse are busy signing subcustody agreements with global custodians such as State Street, Bankers Trust and Royal Bank of Scotland, it is becoming more convenient for funds either bound by US securities law or with conservative internal investment policies to take exposure to Russia’s surging equity market.

But the rush of interest in the Russian market threatens to overwhelm Moscow’s settlement system, which is now the weak link in the infrastructure because of the absence of a central clearing and settlement organization. “We have seen progress in trading, corporate behaviour and overall market infrastructure, but the lack of progress in reducing the paper trail and methods of settlement is the biggest obstacle to efficient domestic trading,” says Gavin Rankin, head of research for the Moscow-based brokerage Troika Dialog.

A central clearing organization may yet get off the ground. The one most likely to succeed is the Depository Clearing Corporation (DCC), which is testing a system it has developed with Russia’s national brokerage association, NAUFOR, for clearing and settling trades in corporate securities over the Russian Trading System (RTS). But most members of Moscow’s financial community are doubtful the settlement problem will be solved soon, since technical obstacles abound and the DCC’s ambitious promises have been heard before.

The most important development in Russia’s stock market infrastructure has been the creation of the RTS, an electronic over-the-counter market similar to Nasdaq in the US. While this dealer-driven system is yet to offer screen-based trading, it has been widely credited with raising liquidity and improving the transparency of the market.

Before the RTS was introduced in 1995, the average spreads between bid and offer prices charged by brokers in Russia’s over-the-counter system often exceeded 20%. These spreads allowed the Moscow office of Credit Suisse First Boston to become the main profit centre for the investment bank in 1994, and foreign and home-grown brokerage firms crowded in on the easy money the following year. But many emerging markets investors were repelled. However, by mid-1996 the average weighted spread was down to 7% and by March it had dropped to below 2%, comparable to other leading emerging markets.

Nearly half of all trading now takes place over the RTS, which was spurred at the beginning of the year by the influx of foreign capital and posted a record volume for January of about $900 million. While volume has eased since then to $20 million to $40 million a day, it is still double the average level in the last quarter of 1996.

More than 70 of Russia’s most liquid companies are traded on the RTS, including the 24 most actively traded stocks that comprise the widely followed RTS Index.

Trading in preferred shares was introduced in September last year. The system now lists the preferred shares of 13 companies, and western funds and domestic investors have been quick to buy them, calculating that the large discounts on preferred to common shares will continue to narrow.

The RTS is used by more than 300 broker-dealers in eight Russian cities, which must also be members of NAUFOR, Russia’s first self-regulatory organization. “NAUFOR is committed to raising professional standards for brokers and reducing counterparty risk,” says Dmitry Ponomarev, NAUFOR president. “Our disciplinary committee has taken a number of enforcement actions for violations on the RTS. We have imposed fines and, in some cases, have expelled brokers from the system.”

The latest incident involved a Russian broker who, in mid-March, traded about $8.5 million of shares in the oil company Surgutneftegaz on the basis of forged documents from the company’s share register. The broker, who has not been identified, was swiftly expelled from NAUFOR, barred from using the RTS and was obliged to reimburse the share purchasers.

NAUFOR launched a second system in December for trading second-tier stocks. These include many of the regional telecom and power generation companies that have become popular with foreign portfolio investors. Blue-chips such as Lukoil, Mosenergo and Irkutskenergo are seen as fully valued, based on their price/earnings ratios, following months of rally in a robust market.

The RTS-2, which now lists about 50 stocks, has already enhanced the liquidity of many second-tier companies and movement up to the RTS from RTS-2 is seen as an upgrade in liquidity and an important boost to a company’s credibility. The jump was made in March by the regional power companies Kubanenergo and Kolenergo, which have been appearing in the investment portfolios of many Western funds recently, while a poor financial picture for the shipping sector and the resulting loss of liquidity demoted the once popular Far Eastern Shipping (FESCO) to the RTS-2.

While the RTS-2 is helping portfolio investors access small stakes in second-tier companies, investors after bigger stakes remain frustrated. “Liquidity is still restricting the market in the second-tier if you want to build a big position,” says Alexander Bubnovsky, the head of equity trading with Alfa Capital in Moscow. “They still have low market capitalization and the employees still hold the bulk of the stocks, making it hard to find a sufficient amount.”

The big blue-chip stocks have been given a liquidity boost from the extraordinary popularity of American depository receipts (ADRs) for Russian companies. ADRs, which are traded offshore, have allowed more conservative foreign investors to gain exposure to Russia and avoid the main shortcomings of its market infrastructure: clearing and settlement, depository and custody requirements imposed by the US SEC, and onerous taxation.

Russian companies gain from an increased international profile from level-one ADRs, which do not raise new capital. They have also benefited from increased investor interest and a surge of liquidity. Companies with ADRs were among the best performers last year.

The enthusiasm for Russian ADRs has astonished even long-time veterans of these quirky derivatives. Tom Sanford, vice-president of the Bank of New York, told a recent conference in New York that US investors bought $5 billion of Russian ADRs last year alone, amounting to 2% of the total market capitalization of all ADRs issued. “I have not witnessed anything like it in my 20 years of work with depository receipts,” said Sanford. The Bank of New York serves as the depository institution for all Russian ADR programmes.

Since the first programme for Lukoil was launched in January 1996, 8.6% of Russia’s total market capitalization is now held offshore in ADRs. Nearly 20% of the shares outstanding of Mosenergo and Lukoil are trading offshore as ADRs. And a recent report by London-based analysts of Salomon Brothers predicts that a total of 15 Russian companies will have ADRs by the end of this year, increasing the share of Russia’s market capitalization held in ADR form to 15%.

The Russian equity market stumbled through its first two years without a legitimate legal framework for trading, relying on a patchwork of conflicting decrees, government resolutions and outdated legislation. But last year the Russian government enacted a Law on Joint Stock Companies, which has been critical in regulating corporate governance, establishing higher standards for information disclosure and specifying rules for shareholders’ meetings.

The Law on the Securities Market, which took several years to implement, was adopted last April and has been effective in regulating the activities of professional market participants and establishing procedures for share issues.

The law also made the Federal Commission for the Securities Market the primary securities market regulator, a role it had previously shared with the Russian Central Bank and the finance ministry. The commission had struggled along, understaffed and underfunded, largely because of its energetic chairman, Dmitry Vasiliev. Late last year President Boris Yeltsin upgraded the commission to ministry-level status; it now reports directly to the president, which positions it for budgetary funding. In the first quarter of 1997 the commission has trebled its staff from 100 to 292 in its central Moscow office and now has a budget for 1,000 regional staff.

Until recently the securities commission could only discourage a company’s management from an errant share issue or shareholder rights’ violation, citing the Law on Joint Stock Companies and using public opinion to encourage compliance.

The commission scored a big victory last October when it successfully urged one of Russia’s largest oil companies, Surgutneftegaz, to make amends for a controversial share issue in which the holding company bought the subsidiary’s shares at well below the market price and did not give minority shareholders the right to buy shares, effectively diluting their holdings.

After the company’s shareholders protested, the commission negotiated a deal on the basis that the share issue was a violation of the Law on Joint Stock Companies. Surgutneftegaz agreed to pay an additional $36 million for the shares and to change its charter to give shareholders pre-emptive rights over future share issues. While the compromise price paid by the holding for the shares was still below the market price, it offered better value for the company and its shareholders.

The securities commission may get a chance to support a legal precedent that could be important for the development of shareholders’ rights in Russia. On March 7 an offshore investment fund, Cambridge Capital Management, filed a lawsuit with a Russian arbitration court to enforce its legal right to proportional representation on the board of directors of Novolipetsk Metal. The Monaco-based fund has a 17.2% stake in Novolipetsk, Europe’s largest steel maker, and has repeatedly been thwarted by the company’s management in its attempts to get a seat on the board. Several other shareholders with smaller stakes, such as the Moscow investment bank Renaissance Capital, have filed separate suits.

Formal complaints have been filed with the securities commission, which supports the law suit, and has sent a team to Novolipetsk to conduct its own investigation. “Right now it is very important that investors use the court system to defend their rights,” says Vasiliev of the Federal Commission for the Securities Market. “When we have several cases resolved through the courts, it will change behaviour and we will gain experience working with the court system.”

Since the beginning of 1997, the commission has been armed with a new criminal code that treats securities fraud, such as supplying false information in a new issue prospectus and operating on the securities market without a licence, as a criminal offence. The penalties for violations range from fines to imprisonment. But a commission spokesman says it is not clear how the Novolipetsk case will be concluded since critical amendments that would allow the commission to enforce the law on joint stock companies have not been added yet to the criminal code.

The commission used the criminal code for the first time in mid-February, when it cracked down on six Russian share registries operating without a licence, filing these first cases under the code with the ministry of internal affairs.

There has been concern in recent years over the risk to investors posed by Russia’s wily shareholders’ registries. Registry risk was a primary concern for investors when most registries were either “pocket registries”, affiliated with a single issuer, or independent entities that registered the shares of only one issuer. Russia has a book-entry system of record-keeping in which only an extract, a copy of the shareholder’s entry in the registry, is proof of share ownership. However, few complaints have been filed.

The structure of the share registry system has changed significantly since the commission adopted regulations and began issuing licences last year. Since mid-1996 the commission has licensed 180 registries, based on rules that include minimum issuers, shareholders and capitalization requirements designed to encourage consolidation.

Regional governments have been developing large registry projects that are absorbing the share registries of issuers in their region. The ministry of communications has established Reestr-Sviaz, which it intends to become the registry for all of Russia’s 85 regional telecom companies. Since the telecom sector’s largest company, Rostelecom, vowed to use the new register many other telecom companies have signed up.

Meanwhile, in Moscow, a number of big companies now use the National Registry Company (NRC), a joint project of the Bank of New York, European Bank for Reconstruction and Development and the International Finance Corporation and a couple of Russian partners. This attempt to create a centralized registry has been a partial success, attracting 32 issuers including Norilsk Nickel, St Petersburg Telephone and Alfa Cement. But it has so far failed to land Lukoil ­ the crown jewel that the NRC had counted on for credibility ­ despite the fact that investment bank Nikoil, which handles Lukoil’s share register, is a founder and shareholder of the NRC.

Despite this progress, foreign investors are still haunted by the memory of the UK-based metals trading company, Trans-World Metals, claiming in 1994 that Krasnoyarsk Aluminium had wiped clean all record of its stake in the company from its share registry. And the following year investors mounted a protest against Novorossiysk Shipping (Novoship), which they claim refused to re-register trades in its shares.

Both companies have since put their registry houses in order, with Novoship transferring its registry to the NRC and Krasnoyarsk Aluminum using the Moscow Central Depository. “We believe the risk of company managers excluding or diluting outside shareholders has been exaggerated, due to heavy publicity about a few incidents, the most recent of which occurred in 1994,” says Andrea Rutherford, a market infrastructure analyst with the Moscow-based Brunswick Brokerage and the former director of communications for the Federal Commission on the Securities Market. “Most of the widely traded Russian issuers have opened professional, technically sophisticated registries in Moscow that has reduced risk and cut settlement periods to one or two days.”

The securities commission has become increasingly sure of its powers as a regulator of the securities market and an architect of its infrastructure. But it must beware the Russian Central Bank, which also competes for regulatory control of the securities market. The commission is struggling to develop its identity under Vasiliev, but because it is governed by a 15-member advisory council composed of representatives of various government agencies, including two central bank representatives, it is vulnerable to pressure from some members.

This was evident last year when a rogue presidential decree was issued that stripped the commission of its ministry status and placed it under the supervision of the Ministry of Finance. The decree was revoked two weeks later by another presidential decree restoring the commission to its original status. The rogue decree was issued while first deputy prime minister Anatoly Chubais, who was then Yeltsin’s chief of staff and is the commission’s most influential ally in the government, was on holiday.

Commenting on the tussle, which was never fully explained, a securities commission official says: “Russia’s big commercial banks don’t like it that the commission follows the American model of broad public ownership, shareholder rights and a strong mutual fund industry.” Russia’s powerful banking sector, backed by the central bank, prefers the German model in which the banking sector is the driving force in the development of the stock market. Its approach is clear from the aggressive acquisition by Russia’s top banks of controlling stakes in choice companies and through the formation of financial industrial groups.

The friction between the securities commission and the central bank continues. The criminal code says banks will be prevented from operating in non-government securities. But in early March the securities commission introduced a new regulation allowing banks to conduct broker/dealer activities, apparently caving in to the strong support for the measure by first deputy prime minister Vladimir Potanin, who as the founder and former chairman of one of Russia’s most powerful banks, Oneximbank, is on the side of the banking lobby.

The commission and central bank have also clashed over licensing share registers, depositories and market participants. In March Potanin appeared to have the upper hand in his open conflict with Vasiliev after the central bank had staged an aggressive campaign to get him ousted. But Yeltsin’s recent cabinet reshuffle is seen as a victory for Vasiliev. Now, Anatoly Chubais, a Vasiliev supporter and a former chairman of the Federal Commission for the Securities Market, has been appointed finance minister and first deputy prime minister with broad control over economic policy, while Potanin has been dropped from the new cabinet.

The dispute between the two institutions is being played out in the most recent market infrastructure development in Russia, the launch of floor exchanges for equity trading. The central bank is backing the launch of equity trading at the Moscow Interbank Currency Exchange (Micex), Russia’s main floor trading venue for currencies and government securities. Trading is expected to begin in April on the Micex in blue-chip companies such as Rostelecom, Mosenergo and Norilsk Nickel. The longer range plans are to create facilities for settlement, clearing and depository under one roof.

The securities commission announced in late February the launch of the Moscow Stock Exchange (MSE), which will compete with Micex by also offering floor trading in equities. The MSE is backed by the commission, the city of Moscow and 170 Russian companies. Its stated mission is to increase market liquidity.

Since most Russian equity trades are conducted offshore to avoid Russia’s tax system, floor trading in equities is intended for domestic investors, such as Russian banks and the newly launched domestic mutual funds.

Rostelecom looks to the capital markets

Rostelecom, Russia’s long-distance telephone company, is to seek funds on the international capital markets for the first time. Eurobonds seem all the rage in Russia and Rostelecom, not wishing to be left out, plans to launch a $100 million Eurobond issue later this year.

Rostelecom controls 95% of domestic long-distance traffic, and 85% of international calls. The company was rated BB- in February by Standard & Poor’s: the same as the sovereign borrower.

Rostelecom first showed interest in raising funds from western portfolio investors in 1995, when it wanted to launch a level-one American depository receipt (ADR) programme. However, establishing a proper registrar for the company’s shares proved a difficult and protracted process. When all was ready at last, Rostelecom decided not to go ahead.

Once 1996’s annual results come out, the company will have three years of audited IAS accounts. According to Yuri Krapivin, an analyst at Renaissance Capital, this means it could launch a level-three ADR programme, or even seek full listing on the New York Stock Exchange. Either way, an issue by Rostelecom would be a coveted deal. One Moscow investment banker points out: “Whether it’s equity or debt ­ it should attract enormous interest.”

The company’s lucrative franchise is unusual, because as Krapivin points out, it comes “without any obligation to subsidise directly investment in the relatively underdeveloped and less profitable local telecommunications market”.

Brokers believe Rostelecom’s management has the ability to make the most of the company’s favourable position. “The management is market-oriented, investor-friendly and progressive,” says one analyst.

So far, at any rate, the numbers have reflected this strength. When the company’s 1995 results came out, a report from Deutsche Morgan Grenfell described them as “nothing short of spectacular”. Net earnings, even corrected for inflation, had tripled, and a 20% revenue gain translated into an 80% growth in operating profit.

Analysts also point out that Rostelecom is insulated from the larger economic problems the country faces. Whether the news is good or bad, more people are using the telephone to pass it on. Both international and long-distance traffic is increasing and looks set to continue to do so.

But nothing in Russia is ever that simple.

The government still holds a 51% stake in the company, and has announced its intention of transferring its stake to Svyazinvest (a holding company which controls many local telecoms operators). This would reduce the possibility of Svyazinvest competing with Rostelecom in the long-distance market, so could well be good news, but the decision has been vigorously opposed by international agencies. The World Bank and IMF are reluctant to allow the formation of another huge monopoly in Russia.

But if the government does transfer its stake in this way, would Svyazinvest allow Rostelecom to make an equity offering? Some corporate financiers believe it would; others believe it would not. A bond offering could similarly be affected by ownership confusion.

In addition Standard & Poor’s, awarding a high credit rating to Rostelecom, warned that it “primarily reflects the Russian government’s current 51% controlling stake in Rostelecom and is not based on the company’s stand-alone credit quality”. Standard & Poor’s states that changes in the ownership of either Rostelecom or Svyazinvest that would effectively reduce the Russian government’s stake in Rostelecom “could weaken Rostelecom’s credit profile and lead to a reassessment of the rating”. Rostelecom would be able to proceed with a Eurobond offering, but the cost of borrowing might be higher.

Such uncertainties will have to be resolved if Rostelecom is to succeed in its objective of transforming itself into a modern telecommunications company. In achieving this, the ability to raise finance abroad is vital. As Andrew Cowley, managing director at United City Bank points out: “By Russian standards, Rostelecom is a very well-run company. In an operating sense, it has got a clear strategy it is following through, but it needs a lot more money than it can raise internally to get its projects going.”