Betting on a brighter future
Russia’s derivatives market has been stunted by a legal association with gambling, which in the past has made derivatives contracts legally unenforceable. Some progress has been made in rectifying this situation, however, as in 2007 futures contracts were officially recognised on the statute books. That gives them – technically, at least – a sound, legal basis. Solomon Teague reports.
Use of derivatives is not completely new to Russia. It was accepted practice before the economic crisis of 1998, according to Sergey Komolov, partner at Hogan & Hartson in Moscow, although even then they were shrouded in legal uncertainty.
Since 1998, however, questions about the enforceability of derivatives contracts have been at the forefront of the minds of those who use them; in the aftermath of the sovereign default, Russian courts refused to enforce certain contracts entered into before the crisis, demonstrating that they regarded derivatives as a form of gambling, not as financial instruments, Komolov said.
Non-deliverable forwards and options are particularly problematic. There are two schools of thought in Russia regarding what an option actually is from a legal perspective, according to Komolov. Some see them as a contract on which one party has the option to renege; and others see them as an irrevocable offer (as opposed to a fully formed contract) to which acceptance has not been yet given.
This uncertainty permeates throughout the industry, with problems such as netting and collateral enforceability holding it back, said Chris Barter, co-chief executive of Goldman Sachs in Russia.
According to Komolov, the Russian central bank has always been uneasy about the situation and has tried to regulate the industry, but this proved impossible without legislation to back it up.
In 2000-2007, changes were made, first, to Russian tax and accounting legislation (codifying tax and accounting treatment of derivatives products) and then to the civil code (granting court protection to derivatives entered into by licensed entities). In a sense, they have now been given recognised status.
In 2007 there was a change to the civil code which declared derivatives enforceable, but this only gave assurances to Russian banks and Russian licensed market participants. Foreign banks and brokerages are still not guaranteed protection in the Russian courts, said one Moscow-based lawyer, leaving “residual doubt” for those foreign players involved.
“To a certain extent the derivatives industry effectively regulates itself, as counterparties do not want to renege on a contract and therefore damage their reputations and chances of doing future derivatives business,” said the lawyer.
The changes have given the industry sufficient stability to support growth, Komolov said, though as yet traded volumes remain low. Yet not everyone in the market is convinced – and that might explain why volumes remain modest. Some bankers pointed out the situation will remain unclear until they are challenged.
“The legal framework for derivatives is less perfect than for cash equities, but it is improving all the time,” said Alexey Sukhorukov, deputy chairman of the executive board at RTS , the number one Russian exchange in Russia. Last year’s change saw the State Duma, the lower house of the Russian parliament, approve the legal change that protects their status in the civil court.
“People said Russia should get into derivatives but I haven’t seen the splash yet,” said Dmitry Snesar, co-head of global banking for Deutsche Bank in Russia, who believes the popularity of such contracts has remained relatively flat over recent years, although he does concede there have been notable developments at RTS.
Given the relative youth of derivatives in Russia, Sukhorukov said the legal framework they enjoy is comparatively rigorous. There have been no major disputes regarding the legality of a derivatives trade since the legal clarification in 2007 to undermine the industry. The biggest question mark remaining regards their tax treatment.
“Tax treatment for legal entities and individuals is different,” Sukhorukov explained, which has led to some level of confusion. But these questions he dismissed as relatively minor in the face of exponential growth. “The development of the industry has, in fact, been accelerating,” said Steven Fisher, corporate bank head of Russia and CIS at Citi in Moscow.
The most liquid instruments on the Russian market are futures on the RTS index that have been available since 2006, and are more heavily traded even than cash stocks on blue chips, overtaken in trading volumes in November 2007.
RTS also offers futures on three sub-indices: oil and gas; finance; and retail. “They aren’t necessarily all liquid, but they are at least available,” said Sukhorukov, though the fact they were launched at all suggests RTS detected some level of demand from RTS clients. The exchange conducted market consultation to assess readiness for different futures contracts, launching them one at a time throughout 2007 as demand, driven by both trading and hedging requirements, was judged sufficient for them to succeed.
There are also options on futures of the indexes and single stock futures. “RTS is in the top five exchanges in the world measured by the number of contracts traded,” claimed Sukhorukov. Measured by the value of the underlying, it is in the top 20.
Fisher cites FX and interest rate swaps as two areas of the derivatives markets that have gained significant traction in Russia. Commodities derivatives are also taking off, to a lesser extent, he said. The fact that these three areas are the ones that have taken root more firmly in Moscow is no surprise: they reflect three of the biggest areas of exposure and concern among Russian corporates.
Some are concerned that commodities derivatives may be held back by a widespread feeling that companies should avoid over-hedging in core businesses where they risk negatively impacting their profits in the good times, said Fisher.
But RTS is more sanguine. “We have been aggressive in developing commodities derivatives,” said Sukhorukov, with the exchange now offering derivatives on Urals oil, gold, silver, a range of oil products including gas and diesel, and sugar.
“They are not all traded heavily,” admitted Sukhorukov, though, as with the sub–index futures, they were only launched when RTS received a certain level of commitment from its customers to trade them.
Interest rate and FX derivatives have also had a relatively weak uptake until now but Sukhorukov said that conditions, especially on the interest rate side, could be taking a favourable turn, with the sub-prime crisis driving interbank lending rates higher. “I expect development in interest rate derivatives to occur quite swiftly,” Sukhorukov said. “The increasing volatility on the rates in the interbank market will help us.”
Compared with the commodities sector, derivatives in FX and interest rates have the advantage that participants in these markets tend to be more financially sophisticated, and are more likely to have had exposure to such products in the past, Sukhorukov said. So although commodities might be expected to experience more volatility, it is unlikely the market will develop so quickly.
Who cares about derivatives?
This leads to the question of where the demand from derivatives is coming from. Advocates claim they are primarily hedging tools: “Demand is not driven primarily by the financial sector or by speculation,” claimed Sukhorukov. “Most of the growth is expected to come from companies that trade the underlying and have significant exposures to commodities prices.”
But Snesar has a different take on the drivers of RTS’s business. “Derivatives are all about leverage,” he said. “Most of the volume on RTS is provided by brokers providing leverage to their customers, giving them exposure to assets without having to sell them positions in the underlying. Now some pension funds and insurance companies can buy derivatives but most Russian companies are not that interested.”
According to Brian Lazell, head of the debt product group at Renaissance Capital, derivatives started to catch on in Russia as Russian corporates observed asset liability management techniques occurring elsewhere.
“Things like FX swaps allow for very proactive ALM in developed markets,” he said. “Previously Russia lacked the sophistication – lacked the awareness – of these kinds of products.” As that changed, inevitably they have started to catch on.
Bob Foresman, deputy chairman at Renaissance Capital, partly reconciles the differing views. “Russians tend to be hard to sell derivatives instruments to,” he said. “A CEO here won’t congratulate his CFO for a successful derivatives trade but will punish a failure.”
However, Russian companies are starting to understand the potential that derivatives offer, according to Foresman. “We emphasise the term ‘risk management’ rather than ‘derivatives’ in order to underscore their hedging purposes. It is not about gambling but rather about responsible risk management and this is increasingly appreciated.”
Increasing sales of software designed to trade and manage derivatives exposures provides more evidence they are gaining traction in Russia. Misys has seen its own Optics software increase its sales in Russia, said Guy Warren, executive vice president of core banking at technology vendor Misys. “This shows us Russians are not just trading more FX but implies they are also using FX derivatives.”
Education is key
“You need to be patient, to educate clients and familiarise them with the available options and be ready when the demand comes,” said Fisher. “There is no point in pushing if finance managers aren’t ready.”
Sukhorukov stressed that a significant part of RTS’ work in developing the derivatives industry has been in educating corporates about the potential benefits of the derivatives industry. “There is interest out there but the commodities markets are less developed [than the financial markets] and so there is still a lot of work to be done. Our job is to sell the clients the idea and the benefits of these products,” Sukhorukov said.
“The Russian government is cautious about derivatives, and about recognising them,” said Andrew Dell, head of emerging markets debt finance at HSBC. “The onshore derivatives we have in Russia are very straightforward, and that is probably a good thing.”
The teething problems Russia is going through in growing its derivatives market are the same as those experienced by Spain and Germany when their markets were getting off the ground, said Goldman Sachs’s Barter.