Ben Aris in Moscow -

After lying fallow for the last couple of years, the green shoots of recovery are appearing in Russia's capital markets. Reforms that have connected the Moscow Exchange to international capital markets and the growth of private pension funds could transform the landscape in the years to come, but this will be an evolution, not a revolution, Evgeny Fetisov, Moscow Exchange’s (Moex) chief financial officer and member of the executive board, tells bne IntelliNews in an exclusive interview.

Moscow Exchange has been putting its money where its mouth is: the leading Russian exchange now has the highest dividend yield of any exchange in the world after it increased the share of profits returned to shareholders in September, paying out 55% of its net annual income to its shareholders, up from the previous payouts of 30% in 2012, 40% in 2013 and 50% last year. “We take what we need to continuing building up the exchange’s infrastructure, but we believe strongly that what is left over after this should be returned to our shareholders,” Fetisov says.

Moex has come to epitomise the best practices of the best stocks that are listed on its boards since Russia’s leading exchanges – the Russian Trading System (RTS) and the Moscow Interbank Currency Exchange (Micex) – were merged in 2011 to create Moex. As a result, the exchange has been one of Russia’s best performing stocks despite Russian equities in general being walloped by the recession and the brouhaha that surrounds the Kremlin’s increasingly aggressive tactics in first Ukraine and now Syria. Moex shares were up this year by 32% as of September 29, against the rises of just 2% for the dollar-denominated RTS index and the 13% for the ruble-denominated Micex index.

Part of Moex's strength is that in addition to being the platform for trading stocks and bonds, it also includes a central depository. This business earns regular fees from holding these assets on behalf of investors as a global custodian, and this income keeps coming irrespective of the swings on the market. It also offers commodity trading, currency conversion, derivatives and other related financial services – in short, a diversified range of income streams.

This pro-shareholder attitude is partly a function of the change in ownership structure of Russia’s exchanges. Previously, the RTS, which celebrated its 20th birthday in September, was largely owned by market participants, whereas MICEX was largely owned by the Central Bank of Russia (CBR). But following the merger at the end of 2011, the exchange boasts a broad ownership and one of the highest free floats on the market.

And in the latest development, Russia’s capital market was hooked into the global financial system when Moex was quietly added to the Clearstream and Euroclear international settlement and clearing systems between 2013 and the middle of 2014. Now investors can buy Russian stocks and bonds directly from the comfort of their own trading desks in London and New York. This investor-friendly approach has made the exchange a regular outperformer in the Russian equity universe.

New role

It’s too early to say that reform of Russia's capital market is complete, but with Moex the country now boasts easily the most sophisticated one in the former Soviet bloc. Moex ranks among the world's top 25 exchanges by total volume of equities traded, and also among the 10 largest exchange platforms by bonds and derivatives trading. As of May 1, the securities of 728 issuers were trading on the platform.

That depth is crucial after US and EU sanctions cut Russian corporates off come the international capital markets, leaving Moex as the only game in town – bar some state-to-state funding by China and the sovereign wealth funds of the Middle East.

Foreign investors have always played a big role in the Russian stock market, and still own rought half of the market's free float, in the hope of cashing in on the transformation of the country to a market economy. But capital markets play a more important role for governments as an essential source of capital. A significant new pool of money is being created for investment into equities via the ongoing pension reforms in Russia that will be channeled through the exchange – and Russian companies are already complaining that development is stymied due to the lack of long-term cheap funding.

Pension money will be the next big step-up for Moex, but reform of Russia’s pension system is not going smoothly. There have been at least two attempts to make sweeping reforms and neither produced much. The cash-strapped government also raided the state pension fund last year by freezing some of the payments, but those funds were unfrozen this year in May and, according to Fetisov, an additional RUB600bn (€8bn) from the funds is available to be invested in Russian assets.

But the government is still stuck for cash and in September talk began again about reintroducing the freeze. The upshot of all the confusion is that the total value of pension assets under management in Russia has risen from about 3% to 5.6% in the last decade as of the end of 2014, according to Goldman Sachs – a fraction of where it needs to be if Russia is going to be able to take care of its pensioners.

Nevertheless, over the longer term Russia’s growing pension resources represent a significant amount of capital that will end up in the equity market and the amount of pension money going into the market is already significant.

The state has introduced new investment-style accounts where anyone investing up to RUB400,000 is eligible to get that 13% income tax refunded if the investment is held for at least one year other and is eligible for capital gains tax relief if they hold the investment for more than three years. These products are proving to be highly popular with the population, which is finally starting to think about old age. “The pension assets under management is not huge by global standards, but this source of funds is starting to be important,” says Fetisov, who cites a recent Goldman Sachs report that estimates pension funds under management will reach a total of $200bn by 2020 in a $1tn economy.

Creating an equity culture

The pension story underscores the challenges that Fetisov and his colleagues are facing: financial literacy in Russia is very low and part of his job is to create the “equity culture” that imbues the more developed markets; only about 3% of the Russian population have any money invested in equities. The problem has been a series of unlucky coincidences. President Boris Yeltsin introduced the legal framework for mutual funds in 1995 and the first appeared in 1996 – about 18 months before the markets collapsed in the 1998 financial crisis.

More recently a similar thing happened when the government tried to rope the population into the “people’s IPO” listing of VTB Bank in May 2007. Russian punters put more than $1bn into the issue – only to suffer massive losses about 18 months later during the 2008 financial crash.

Russians are now, unsurprisingly, wary of securities and mutual funds. Still, the most sophisticated can see there is money to be made once the bear market ends and Fetisov says Moex has more than 1.1mn retail accounts, of which about 70,000 are actively trading. The amount of money invested in the stock market by day traders has become large enough to have a real impact on the index.

The bigger problem is that like the day traders, what passes for institutional investors in Russia are also only speculating on short-term gains. The lack of pension or insurance funds means there are few long-term investors in the market. Even the foreign investors, which used to own about half of all equities listed, tend to be hedge funds, which have at best a six-month time horizon. This short termism makes the market shallow and volatile. “We want to see a more buy-and-hold culture, as that would give additional depth to the market. We also need to develop the domestic investor base – both institutional and retail investors. The introduction of individual investment accounts this year will help as they are geared to one- to three-year investments. Over 50,000 accounts have been opened in the first nine months of this year, which together are worth over RUB6bn,” says Fetisov.

A shortcut to improving the investor profile would be for someone to set up some domestic Exchange Traded Funds (ETF), says Fetisov. There are several foreign Russian-focused ETFs. ”Why do we not have any ETFs here in Russia? The market is certainly big enough, and they are a simple and less risky way for people to invest in Russian equities. However, so far there’s been no interest in establishing domestic funds,” says Fetisov.

Low valuations

The pile of problems – economic and political – that Russia is currently enduring has driven share prices down to rock bottom levels. But Fetisov argues on a fundamental basis that can’t last forever, although he won’t speculate on when any recovery could begin.

Russia has always had an emerging market discount applied on its equities and on top of that a specific “Russia-risk” discount. On a valuation basis Russian stocks should be attractive, but a deep recession and lots of war-talk makes betting on Russian equities very risky right now. But Fetisov queries whether this is still appropriate to today's market. ”Russia has something like a 50% discount to other emerging markets, however we have corporate governance here, transparent accounts, and the well-functioning financial infrastructure. The size of this discount is not justified – a large part of it is due to sentiment,” he says, adding that, “another part of it is due to the missing domestic investor base.”

Russia introduced a new corporate governance code over a year ago, which includes aspects like new listing rules, which will take effect at the beginning of 2016. There are also new rules to force independent directors onto company boards to oversee operations. Taken together, the new rules are another step forward in improving Russia’s corporate governance.

The financial sanctions are also holding back another reform that joining the international settlement system made possible. Now that international traders can buy locally listed stocks on their own systems, the need for depository receipts (DR) – an international proxy for locally listed shares and long a hallmark of emerging market stocks – have become superfluous.

As the price of the DRs is usually slightly different from local prices, investors were steadily buying DRs and converting them to their local equivalents and making money on the arbitrage. However, the sanctions include a clause that prohibits the issue of “new” shares in international markets. Ironically, the US Securities and Exchange Commission has ruled that converting DRs to local shares does not involve the issue of “new” shares, as the local shares already existed, whereas the EU ruled that the conversion does produce “new” securities and so has banned the practice.

If the EU does drop its financial sanctions in December, which is a distinct possibility, then this business will restart and should boost Russian share prices, as DRs are a lot more expensive to hold than locally listed shares. ”DRs cost an average of 8% to 14% of dividend payments. It gets very expensive to trade DRs if you can do the same with local shares,” says Fetisov. “Investors are still using DRs as a legacy of the transformation from an emerging market to a increasingly developed one.”

The end of DRs would be welcomed by Russian companies, as they raise the cost of an IPO significantly. The company has to satisfy two different sets of regulators and analysts simultaneously on two separate exchanges with two sets of fees, ultimately reducing the size of the free-float to each class of investment.