New Custody Challenges in a Maturing Securities Market

Stephan Tomljanovich

Custodians wishing to operate in new niches opening up in the Russian securities market are facing uncertainty in the near future and will need a lot of creativity and additional investment to succeed, writes Stephan Tomljanovich, Head of Custody at Russian banking major ROSBANK. While not all maybe willing to take the trouble, the price of inaction may well prove to be much higher, he warns.

The Russian economy has overcome most of the challenges it faced twenty, ten and even five years ago. Gone are the central planning and universal deficits, hyperinflation, a criminal free-for-all, budget dependence on IMF lending and the growing short-term debt pyramid. So too the problems of excessive foreign debt and expected disintegration of the national infrastructure. Dynamic growth, budget surpluses and booming consumption have come to characterise the Russian economy at least from the medium-term perspective. The fact that GDP growth of over five percent achieved in the first half of 2005 was universally considered inadequate is a reflection of the prevailing mood. Despite the cautious stance of the rating agencies, Russia's sovereign rating is firmly in the investment-grade zone.

However, even after twenty years of reforms, the Russian economy is still largely based on Soviet "investment heritage". The majority of industrial companies and households still use Soviet-made equipment and durable goods. This over-depreciated inheritance will have to be replaced in the next five to seven years, as financial and political stability is expected to hold at least until the presidential elections of 2012. While this translates into the scope of investment opportunities not seen since the start of the industrialisation of China, most of them lie beyond the traditional range of instruments (a dozen "blue chips" and government bonds) familiar to foreign portfolio investors and their global custodians.

The main indicator of the Russian stock market - RTS index - marked its tenth anniversary by reaching new record highs. Russian stocks are ten times more expensive than ten years ago and 25 times higher than the depths they plumbed in the wake of the Russian default in September, 1998. The turnover of the country's largest stock exchange exceeds $1 billion per day. A large proportion of the funds fuelling this boom comes from foreign portfolio investors. And although the issuance of local corporate bonds market is doubling every year and local IPOs are no longer a curiosity, the bulk of portfolio investors' funds is focused on the secondary market and has not become a substantial source of funding for local companies. Limited choice of instruments in the secondary market brings about overheating and makes these speculative investments even more vulnerable to price corrections.

The secondary market infrastructure has improved significantly in the last few years and, although it remains fragmented, is quite reliable and inexpensive. Foreign institutional investors traditionally use global custodians to access the local market. Their positioning as a single point of entry to the local market appears invincible to competition from domestic players, at least for the short term. Quite naturally, global custodians generously price this competitive advantage into their service fees.

Local custodians service mostly local investors, providing basically the same services but for a much lower price. With almost eight hundred licensed custodians in this segment the competition is fierce, while market consolidation is still some way off. Although many local custodians act merely as brokerage back-offices, providing basic custody services virtually for free, there is no apparent trend to outsource this function to larger competitors, because the considerations of client base protection still outweigh the logic of cost optimisation. Most domestic investors are unlikely to use a global custodian due to price considerations, but the situation begins to change, at least for wealthy Russians, as several international banks expand the range of private banking services available to this group.

The situation of custody services being a mere supplement to secondary market brokerage is changing with the ascent of the new breed of domestic investors -investment and pension funds. Although this client group first appeared back in 1996, its rapid growth started during the last five years. With the total value of assets held by the most popular unit investment funds (a.k.a. PIFs) and pension funds exceeding $1 Obn, these two groups already provide a significant part of revenues for many local custodians.

According to Russian legislation, the "special depository" function (combining custody, fund accounting and control services for investment funds) is mandatory for both unit and pension funds, making these two groups a captive clientele for custodians (unlike other types of investors, who have an option of choosing a registrar or a clearing depository). "Special depository" service in the local custodian's product mix may provide stable revenues and help develop new products for other types of funds, but requires separate licensing and additional technological and operational efficiency, as PIFs have to calculate unit value on a daily basis. Large custodian banks improve their competitiveness in this segment by providing PIFs with a complementary service of unit distribution via their branch networks. The "special depository" function may also serve as a pass to the booming Russian real-estate market, as many funds either directly purchase real estate or invest in mortgage-backed securities.

Another factor, affecting the long-term competitive landscape in the Russian custody market is the expected emergence of the national Central Securities Depository. Making the secondary market infrastructure fully compliant to the G30 recommendations, the CSD will force global custodians to redefine their business model in this market. They would no longer be able to present themselves to investors as a single point of entry to the chaotic and fragmented market. Custody fees would fall dramatically, putting in question the commitment of many players to this business. The custodians intent to stay in the market will have to develop value-added products like securities lending and fund accounting, introduce advanced technologies diminishing transaction costs and expand their client base. This may trigger much-needed consolidation based on the increased technological capabilities of large local players and/or several global players interested in developing a local franchise.

The situation of custody services being a mere supplement to secondary market brokerage is changing with the ascent of the new breed of domestic investors - investment and pension funds. Although this client group first appeared back in 1996, its rapid growth started during the last five years. With the total value of assets held by the most popular unit investment funds (a.k.a. PIFs) and pension funds exceeding $10bn, these two groups already provide a significant part of revenues for many local custodians.

The balance of power between global and local providers is not clear, as international players enjoy the advantages of an extensive product line and better technologies, while Russians may rely on better price levels and local expertise. In any case, both groups will have to enter each other's turf, with the largest local players trying to sell their services to international funds and global custodians addressing local clients. Both sides may draw inspiration (or warning) from the example of Computershare Inc., actively expanding in the adjacent Russian registrar market.

As competition further intensifies, the custodians are starting to look beyond the secondary market. One of the interesting options is providing services to direct investors (both Russian and foreign) involved in the rapidly growing Russian M&A market. The total value of M&A deals in the first half of this year grew 36 percent to $8.5 billion, roughly equal to the total volume of deals in Central and Eastern Europe. According to Russian sources, the volume of the domestic M&A market is almost three times higher. As capital mobility spreads from the "blue chips" to mid-cap companies, more and more of their owners become aware (sometimes painfully) of the need to protect their investments against hostile acts and ensure their rights in managing the business.

Although foreign direct investments in Russia has doubled in the first half of 2005 to reach $9.3 billion, it still falls short of the Russian economy's requirements and does not exceed ten percent of the total investment flow. Private-equity and venture funds have reappeared in the market in the last two years, but despite all the positive developments, investing in Russia is still not what you may call a textbook case. Apart from over-publicised complications of corruption and crime, this process has purely economic peculiarities investors have to take into consideration in order to minimise surprises they receive. And that is where local partners, e.g. custodians, can provide a lot of added value - from helping file tax reclaims with Russian authorities and proxy voting to preventing manipulations with the shareholders' register and arranging escrow settlement for buying or selling strategic stakes in the company.

The growing wealth of Russian businesses allows them to look abroad for direct investment opportunities, while currency regulation requires them to record their holdings via a domestic custodian. Russian companies are estimated to have at least $5bn earmarked for large acquisitions abroad this year. Despite economic and political problems, integration with CIS countries goes forward and the increased flow of Russian investments to these countries is very likely. Russian infrastructure organisations still have an opportunity to lead regional consolidation, thus providing portfolio managers and custodians with a single point of entry to the financial markets of the former USSR. The liberalisation of currency regulations allows high net worth individuals to consider portfolio investments in foreign equities and bonds as a completely legitimate option.

Private-equity and venture funds have re-appeared in the market in the last two years, but despite all the positive developments, investing in Russia is still not what you may call a textbook case. Apart from over-publicised complications of corruption and crime, this process has purely economic peculiarities investors have to take into consideration in order to minimise surprises they receive. And that is where local partners, e.g. custodians, can provide a lot of added value - from helping file tax reclaims with Russian authorities and proxy voting to preventing manipulations with the shareholders' register and arranging escrow settlement for buying or selling strategic stakes in the company.

The factors stated above make the role of a global (or at least regional) custodian for Russian investors in-creasingly appealing for large domestic custodians as a useful supplement to their product mix. This service has not been massive so far, but the demand is likely to grow after the liberalisation of currency regulations in 2007. As far as the access to developed markets is concerned, local custodians would be prudent to form alliances with global players, while markets like Kazakhstan and Ukraine may be entered directly or via local providers in these markets.

The custodians wishing to operate in these new niches of the Russian market are facing uncertainty in the near future and will need a lot of creativity and additional investment to succeed. Not all would be willing to take the trouble. But the price of inaction may well prove to be much higher.

 

Раздел обновлен 19.05.2011