When Russia hooked its capital markets into the global financial system in 2012 it caused a revolution. Billions of dollars poured into the local government bond market from overseas and foreign investors now account for a record 34% of all the outstanding Ministry of Finance treasury bills, the so-called OFZ, worth RUB785bn ($12.7bn) as of the peak this February.
The international settlement and clearing company Clearstream is hoping to repeat the experience by including more countries from Eastern Europe into its system. Pilot programmes are already working in Armenia and Georgia and later this year the cash-strapped capital markets in Kazakhstan and Ukraine hope to join the party as well, says Clearstream.
As part of a comprehensive market reform that included merging the two largest exchanges – the dollar denominated Russia Trading System (RTS) and ruble denominated Moscow Interbank Currency Exchange (MICEX) — into Moscow Exchange (MOEX), as well as setting up a central depository (CSD), the key part of the reform was making the whole domestic system compliant with the two international clearing and settlement companies Euroclear and Clearstream. Adding these two companies meant that investors in London and New York can buy and trade local government debt without going to the cost and inconvenience of setting up accounts with local brokerages. OFZ trades appear on their terminals everywhere in the world with a trading floor.
Compliance departments love the new arrangement as at a stroke you get rid of a string of counterparty risks from banks and brokerages operating in someone else’s jurisdiction, not to mention the considerable cost savings that can be made. The local brokerages loved it less as it basically ended a business from which they earned lucrative fees, so the reform catalysed a trend that had already started – Russia’s private investment banks and broker/dealers were rapidly taken over by the country’s big state-owned banks and those that remained have shrunk in size and importance.
But for the government the shiny new capital market has been a godsend – especially in this time of sanctions. In the past the Russian government has issued some $7bn of Eurobonds a year to help finance the budget, and Russian banks and companies have been even more active in tapping the long-term cheap money that can be found abroad. Now the domestic market is hooked up to London it has become even easier for all these players to raise money. The Russian budget deficit is increasingly funded by foreign investors buying ruble-denominated assets
The Russian government is issuing up to RUB1 trillion ($16.1bn) of OFZ a year as international bond traders have largely ignored the political row between the Kremlin and the west. Russian OFZs have been the hottest emerging market bond for several years now as they pay handsome yields and are backed by Russia’s rock solid macro fundamentals. Drilling down into the ownership, fully half of the fixed rate version of the OFZ are owned by foreign investors, according to MOEX.
Taking the party to the rest of the region
Now Clearstream wants to take the party to the rest of the region. The international clearing and settlement company has already run a pilot scheme to hook up the Armenian and Georgian capital markets to the international settlement system, and now is planning to add both Kazakhstan and Ukraine this year.
All these cash-strapped countries are hoping to see similarly large inflows yield-hungry international investors to those that Russia has enjoyed.
The trouble with most of the other capital markets in the region is they are so small. Clearstream already works on 56 markets but it can’t just add everyone.
“The OFZ programme costs multiple hundreds of thousands of dollars to implement as everything has to be EU-compliant which makes a lot of work,” says Jan Williems, vice president of market development at Clearstream Holding.
Russia has a big and sophisticated market and all the assets on the market are of interest to foreign investors, from local government debt to corporate bonds. That is not true for most of the surrounding markets, but Williems said Clearstream’s clients were interested in local government debt in all the frontier markets, as although these exotic bonds are risky, they pay extremely well and government debt is probably the least risky of the assets in any country. If you are going to move into a new frontier market then the local government debt offers the most appealing risk/return rewards.
The daily turnover in Russian OFZ bonds on the secondary market runs to the billions of dollars, whereas secondary market trading volumes in Ukraine are a mere $20mn a day. None of the surrounding markets can afford to pay the high prices full integration with Clearstream’s system would cost, so the company came up with a budget solution.
“For other, smaller, markets it doesn't make economic sense [to set up the system Russia has]. We are not the Mother Theresa of the bonds markets,” says Williems. “We have the ambition to cover all asset classes but our clients said they were chiefly interested in local government debt so we worked out a compromise and scaled down version which we trialled in Georgia and Armenia. There is not point in building a Ferrari when what is actually needed is VW Golf.”
Georgia and Armenia were chosen as the Guinea pigs in what Clearstream has dubbed its One Belt and One Road strategy (hat-tip to China), as they are small, open, well regulated, and have cooperative central banks and legislatures that were willing to do all the regulatory reforms needed.
“Now investors don't need to have a local custodian. The traders love the bonds but their compliance hated the cross-country risk. That has gone once they join Clearstream,” says Williems.
The Kazakh integration will start in the second quarter of this year, whereas Williems is “hopeful” that he can make an announcement on Ukraine starting the same process this summer.