A new law sailed through the Duma, the Russian parliament, in the first of three readings this June, putting derivatives on a firm legal footing for the first time. Futures and options were previously governed by the same rules that regulate casinos.
Derivatives trading has been the fastest growing sector in Russia’s financial arena in the past two years. Total volume has grown from $13bn in 2005 to $1bn a day by the middle of this year, according to industry experts.
Futures for deliverables – such as grain and oil – already enjoyed some protection, as Russian law saw these deals as sales contracts that are covered by the civil code. But more sophisticated products for non-deliverables – such as an option to buy a stock at a set price in a month’s time – were in a legal limbo that effectively treated them the same way as betting on a roulette wheel.
No longer. Russian president Vladimir Putin is personally pushing a raft of financial reforms to deepen and broaden the financial markets as part of what is becoming a Kremlin crusade to develop Russia’s financial markets and diversify away from raw materials exports.
Mr Putin’s drive to create a futures market was launched in May’s state of the nation speech, when the president also called for a rouble-based commodities exchange and an acceleration of the programme to make the rouble a fully convertible currency. Domestic futures trading in oil and
gold were launched in June at the same time as the final restrictions on rouble conversion were dropped, six months ahead of schedule.
Banking applications
Russia’s banks are starting to gear up to play in the ballooning market. Vnesheconombank and Citibank applied for and received derivatives licences in June, allowing them to trade in futures and options. In all, 17 banks operating in Russia have applied for these licences and more are expected.
At the same time, Russia’s two rival exchanges, Micex (Moscow Interbank Currency Exchange) and RTS (Russian Trading System), have been rolling out option products in an effort to make this new market their own.
The first futures contracts were traded on the St Petersburg exchange in 1992, but the business never took off. However, buoyed by constant gains, the RTS re-launched the futures trading business on its Forts (Futures and Options on the Russian Trading System) market a few years later, which has picked up momentum in the past 18 months.
The market remains very narrow with only six stocks sporting individual contracts. There are a few interest rate products on offer, with the future index performance being the most popular by far. However, renewed volatility in Russia’s equity capital markets will drive the futures market, say analysts, as investors consider locking in the gains already made.
Plain vanilla offerings
Troika Dialog became a pioneer in the futures market when it set up a dedicated futures and options desk in 2005. Chief trader Georgy Mirel says that option deals remain simple and opaque as most are over-the-counter (OTC), but the market is growing very fast.
“Most options are still a plain vanilla market. Some 90% of the deals are simply futures calls. The more exotic products will come. Many clients are thinking about derivatives but have yet to test the market,” says Mr Mirel.
The problem with the OTC market is that it is very hard to get a fix on what price the market is setting for trades, so the first thing Troika did was place two-way, buy-sell prices on a screen so that investors could judge at what level they wanted to price their options.
“Before we did this there was no firm pricing,” says Mr Mirel. “Transparent prices are what triggered the real-time trading in options.”
Ever since, volumes traded on Troika’s option desk have grown exponentially. Since the bank launched its services a year ago it has seen volumes more than double to several hundreds of millions of dollars and expects them to double each year for at least another two years.
Futures trading on the commodity exchange has been growing more slowly. The RTS added futures in oil and gold to the existing dozen blue chip, interest rate and index products in June. However, on the first day just 5342 contracts were signed worth $3.4m. Gold trading produced a similar result.
No one expects Moscow to become a new hub for oil and precious metals trading overnight. Roman Goryunov, RTS vice-president, told journalists at the launch session for oil and gold futures trading that the RTS would be happy if 100,000 contracts were signed by the end of the year.
So far the market has averaged about 2500 contracts a day compared with the average 35,000 contracts for Brent trading on the oil futures market in London, where the basic contract unit is 1000 barrels rather than Russia’s basic unit of 10 barrels per contract.
But interest in options is growing fast as the easy money of the past five years is clearly a thing of the past. Between the start of 2004 and the end of 2005, Russia’s market capitalisation has risen by 183%. Several factors have driven the gains, the most important being sky-high commodity prices and low global interest rates.
US contagion
In May, the US Federal Reserve bank raised interest rates to 5%, sparking a sharp sell off that saw Russia’s leading RTS index fall by a quarter in a matter of weeks. More recently, signs of a slowdown in the US economy have spooked investors in Russia again, who are afraid that falling commodity prices will take the wind out of economic growth as raw material producers still account for the lion’s share of Russia’s exports.
Investors remain nervous and share prices bounced about in August and September as they reacted to every piece of economic news coming out of Washington.
“The days of 100% annual gains are clearly over,” says Mr Mirel. “In the past, investing in Russia was all about when you bought rather than what you bought. That is no longer true.”
At the same time, the valuations of Russia’s leading companies have risen to the point where investors are starting to think about locking in the gains they have already made by hedging. The May sell off marked the return of volatility to the equity capital market. But hedging against volatility or a sell off is easier said than done given that Russia’s equity capital market remains narrow and shallow.
“The Russian market is illiquid, with only 12 stocks trading in any volume at all and there are only about four Russian stocks that you can short that won’t get called away,” says Bill
Browder, manager of Russia’s biggest hedge fund, Hermitage Capital, which has returned an average of 36.6% per year since inception.
“You could, in theory, short indexes but there is too little volume. There are also options, but as a 12-month put option would cost 16%, the market would have to fall 16% to be worth it and if you think the market might fall [that much] you have ask if you want to be there in the first place.”
