Ben Aris in Moscow -

"[Russian depository receipts] are dead," Mark Banovich, a managing partner of Latham & Watkins, declared to delegates at the London Stock Exchange's fourth capital markets conference in Moscow in February.

Last year's introduction of the Russian version of the widely-used global depository receipts (GDRs) - proxy shares that allow stocks listed on one country's exchange to be listed and traded on another – should have been a major step forward in the development of the Russian capital markets. However, the Kremlin ballsed up the reform by not paying enough attention to the details: the rules governing their use give investors rights, such as preemptive rights to buy additional share issues, but contradictions between the Russian legal regime and the foreign regime where the underlying shares are actually listed mean that holders of these RDRs can't exercise those rights.

Reforming Russia's domestic capital markets shot to the top of the Kremlin's political agenda in April 2008 - six months before the flaws in the market were highlighted in spectacular fashion as the stock market went into a "death spiral" and lost three-quarters of its capitalisation in a matter of weeks.

The Kremlin wants to turn Moscow into an "international financial centre" (or an IFI, but not to be confused with the World Bank's commercial investment arm). And not before time. Moscow's two stock markets - the Russian Trading System and Micex - have grown exponentially in the last 10 years to have a combined market capitalisation of over $1 trillion and with daily trading volumes of several billion. Together, Russia's markets account for about half the value of all listed companies in all of Central and Eastern Europe.

So far, the Kremlin has been using fairly heavy-handed tactics to force companies to list at home. It banned big companies from listing all its shares on, say, the LSE: currently, Russian companies can float up to 30% of their shares in London, while those that have been dubbed "strategic" are limited to listing only 25%.

A big part of this initiative was the introduction of RDRs last year. The likes of Microsoft and Shell are unlikely to rush to list in Moscow, but the RDRs are designed to allow companies with all their assets in Russia, but registered in offshore centres like Cyprus or the British Virgin Islands (ie. technically foreign companies), to easily bring their shares onshore.

The trouble is that most local companies have failed to list anywhere, so the regulator, the Federal Service for Financial Markets (FSFM), has slowly dropped the amount that has to be listed at home, says Banovich, probably the best-known depository lawyer in Russia. "The FSFM keeps lowering the limit on the number of shares that companies have to list at home, but the liquidity [of listed shares] never gets any better," Banovich told the conference. "Russian companies are voting with their feet. If they are going to IPO or do a [depository receipt] programme, they set up a offshore company."

At the start of February the FSFM effectively admitted defeat. "Russia's Federal Service for Financial Markets is ready to lift its restrictions on Russian shares' placement on foreign stock exchanges," Vladimir Milovidov, the FSFM head, said on February 4.

Conflicting rules

Part of the problem is that the Russian rules clash with regulators' rules in other markets, making it impossible for Russian-listed companies to list elsewhere as well. For example, if a Russian-listed company with depository receipts in the US wants to issue more shares, it is obliged (under Russian rules) to offer all investors a preemptive right to buy the new shares. The problem is that this is an "offer to invest" under US rules, which means the Russian company should be supervised by the US regulator - an extremely costly and restrictive process that few Russian companies are prepared to do. The upshot is these companies can't issue more shares.

While the FSFM has signed off on cooperation agreements with most international exchanges, including Hong Kong, which hosted Russian metal giant United Company RusAl's IPO in January, it has failed to sign deals with the UK Financial Services Authority and the US Securities and Exchange Commission - home to the bulk of the world's equity trading. "It's a clash of inflexible regulatory systems," says Latham & Watkins' Mark Banovich.

Even if Russia's regulatory framework can be made to dovetail with those of London and New York, the Kremlin will still have its work cut out; many of the main capital market building blocks are still missing. Despite the size of the daily trading volumes, Russia has virtually no domestic institutional investors, pension funds, mutual funds or insurance funds, which traditionally comprise about two-thirds of the equity investment. As all the portfolio investors are either foreign hedge funds or local banks, the money is "hot" and the market volatile, dominated by short-term investors. Building up a solid basis of long-term institutional investors is a prerequisite for making the domestic capital market work and still far in the future. "Russia has a demand side problem - companies can't sell their shares at home. But the state is still coming up with supply-side problems which are not addressing the issues," says Banovich.