Ben Aris in London -

Since the London Stock Exchange (LSE) and Russia's Moscow Interbank Currency Exchange (Micex) joined forces in February 2006, some 38 companies from the CIS have listed in London, most of them Russian companies, and they are now amongst the most actively traded stocks on the exchange with a turnover of about $165bn in the first half of this year.

It was a natural partnership. Alexander Potemkin, the CEO of Micex, explains there is simply not enough money in the Russian domestic market to be able to absorb a placement of more than about $400m-500m. Moreover, under Russian rules, a company that is intending to float on an international exchange must, by law, first list at home.

"It is a symbiotic relationship," says Chris Gibson-Smith, chairman of the LSE. "The relation between an international market, like the LSE, and a domestic market, like Micex, allows us to cater to the deepening demand in the CIS countries and especially Russia. London is becoming a home from home for many of these companies seeking better access to the capital on the international market."

The backbone of this relationship are depository receipts - a proxy where local shares are bundled together into packages that can then be listed and traded on international exchanges.

"Depository receipts have already become a very liquid and actively traded market segment for the LSE. There have been 2.5m contracts signed since the launch of the Russian IOB index [that tracks the depository receipts on the LSE] in December 2006 worth more than $7bn, and more than 900,000 contracts were signed in July this year alone," says Gibson-Smith.

All this money and activity is having a salutary effect on Russian companies, who now better understand the impact that corporate governance has on their share price, says Gibson-Smith.

Work in progress

As with elsewhere in the Russian economy, the state is keen on this sort of tie-up. While reforms to Russia's judiciary, administration and social services have languished, the Kremlin has been pushing reform in the financial sector as hard as it can over the last few years.

President Vladimir Putin's decision to appoint Viktor Zubkov, the former head of stock market watchdog the Federal Service for Financial Markets, as prime minister on September 12 underlined the importance of the domestic equity markets to the Kremlin's long-term plans.

However, while Russia's two main exchanges - the Russian Trading System (RTS) and Micex - are growing rapidly they both have only just started the process of introducing the more sophisticated products available elsewhere. And Russia's investment community is still shallow, leaving the domestic markets vulnerable to external shocks, such as the current international credit crunch brouhaha.

In an effort to develop Russia's companies as fast as possible, the Kremlin is encouraging tie-ups with foreign companies that can bring real know-how and expertise to the their Russian partners. "Just after a few disturbing weeks in August, our exchange was visited by [then] Prime Minister Mikhail Fradkov," says Potemkin. "The prime minister was pleased to hear about all the progress we have made, but said that Micex is not a fully fledged stock exchange yet. There is still a lot of infrastructure that is simply missing."

The development of Russia's exchanges rose to the top of the agenda of Fradkov's cabinet in September 2004, when the PM famously said: "I wouldn't invest anywhere in Russia." If Fradkov were an investment bank analyst, he would have been sacked long ago after the capitalisation of the Russian stock markets rose 10-fold to top $1 trillion since that meeting.

"There is a well-developed bond market [on Micex], but Russia doesn't have the full range of instruments needed by traders - especially acute is the lack of derivative products," say Potemkin. "However, since 2004 the cabinet has pushed through reams of new legislation, including a law on derivatives that is close to finished."

Deepening and diversifying the domestic pool of investors is a problem that will take longer and be much more difficult to achieve. One of the ideas floated at the September 2004 meeting was to take the assets of the State Pension Fund and invest part of them in the domestic equity capital market. But Russia lacks any significant domestic institutional investors and while the number of individual Russian investors taking a punt on local company shares has risen to half a million, the retail end of equity investment, including the nascent mutual fund industry, accounts for no more than about $15bn of the total market capitalisation - or less than 2% of the total.

"The Russian market is very sensitive to the whims of short-term international investors," says Potemkin. "External shocks are very quickly reflected on the Russian markets."

Some $90bn of foreign money was invested into the Russian equity markets in 2006 - a record year that saw the leading indices rise over 70% year-on-year. But when the credit market shock hit international markets on August 21, some $2.5bn left the market in a day and more than $10bn flowed out over the whole of August, causing the leading indicies to give up all the modest gains they had made this year.

Still, analysts say it could have been a lot worse and were encouraged that the falls on the Russian market have been relative modest in comparison to some of Russia's emerging market peers.

"The market index fell by 6% in August, but the main investors - both domestic and foreign - have not panicked and are holding on to their long positions," says Potemkin. "Our market has been moving sideways this year, but the recent crisis has not altered our plans... This crisis is a test of the [Russian] markets' maturity. But after a pause the IPO process will build again as the list of companies with plans to float is long and growing longer."

Russian Depository Receipts

One of the oddest quirks of buying the shares of some of Russia's biggest companies is that they are not actually Russian. All the employees may work in offices in Russia or at gold mines and oil fields in the country, but as the legal entity is actually registered in some balmy offshore haven, many of Russia's corporate giants are technically a foreign company.

This causes a real headache for the financial authorities that are trying to broaden the base of assets available to Russian portfolio investors, as several of Russia's bluest chips are off limits to domestic investors.

The fix? The Duma is currently considering laws to create a Russian Depository Receipt (RDR). These will be proxies that allow "foreign" companies to package their underlying shares and list on Russian exchanges. Although the likes of General Electric or Unilever are unlikely to stampede towards listing their shares on Russian exchanges, the likes of TNK-BP or United company RusAl - which are registered in offshore havens - just might.

The introduction of the RDR is an attempt to solve a thorny problem that has been plaguing the Federal Service of Financial Markets (FSFM), the stock market watchdog. The regulator's previous chief Oleg Vyugin, who stepped down earlier this year, was concerned that Russia's equity markets were losing out to foreign exchanges. He introduced new rules that force Russian registered companies to list at home before they can IPO in London or New York. But this rule only applies to companies registered in Russia, so Vyugin had to find a way to apply the same rule to obviously Russian companies with all their assets in Russia, but registered somewhere else like Cyprus.

The problem was how to differentiate these companies from an obviously foreign company, like IKEA, that is investing heavily in Russia. Any definition the FSFM set up could easily be dodged by a determined Russian company and as Russian companies increasingly invest heavily in neighbouring countries and further afield, the distinction is becoming more and more muddled as time passes.

"The introduction of the RDR is the front-end of the solution. It creates a vehicle that allows these 'foreign-Russian' companies to list at home. However, setting up rules that will force these companies to list at home is a pratical impossibility, so the most likely solution will be that the Kremlin uses administrative methods to 'encourage' these companies to list without any formal requirements," says one analyst who prefers to remain anonymous.

The first RDRs will be launched in November on Micex, worth about $200m, but the exchange says it expects the volume to build to $1.5bn over the next year.

Send comments to The Editor