Graham Stack in Berlin -

Ukraine's leading index that tracks trading on the PFTS has defied the gravity of the political situation by more than doubling over the past year. But gaping holes remain in the market's infrastructure that make the gains look like a sleight of hand to some.

By the end of the first week of October, the index had regained all the ground lost during this summer's collywobbles over the US subprime debt debacle and even topped its all-time high of 1,000. A year ago, the market was trading at 300 - and even that was after some spectacular gains from the rise in interest in Ukraine's equities in the wake of the so-called Orange Revolution of 2004-05.

However, despite the growing interest in Ukraine's equity market, which looks like it will take over Russia's mantel as darling of the emerging market universe in Eastern Europe, the market infrastructure remains rudimentary at best. Some analysts wonder if investors have got ahead of themselves as the government scrambles to catch up and rams through a raft of new legislation and tries to fill the lacunae.

NASDAQ of the East

Ukrainian brokers used to refer proudly to the PFTS as the Ukrainian Nasdaq - meaning it was more an over-the-counter (OTC) system than a stock exchange. But this is changing fast.

The PFTS runs a nationwide electronic trading system based on real-time quotes and both quote-driven and order-driven market mechanisms. The PFTS Index has been the Ukrainian benchmark since 1997 and now dominates trading volumes in the organised securities market, as it accounts for all trades in government and municipal bonds, 99% of all domestic trade in corporate bonds and 93% of share trades.

2006 was a watershed year for the PFTS: $1.182bn sales volume represented a massive 100% increase on $665mn in 2005. "In fact, only in 2006 did the PFTS start moving towards becoming a full-scale stock exchange," says Oleksandr Klymchuk of Kyiv's Concorde Capital.

The PFTS was finally made into a licensed stock exchange in 2006 and now it's rebuilding its procedures as it heads toward becoming a fully operational exchange.

But there is still a long way to go. "Only 10% of trading volume are registered deals - the remainder are OTC, with the PFTS used as a price indicator by participants," says Klymchuk.

Thus, a portfolio manager seeking or having exposure to Ukraine is confronted with low liquidity, volatile profits of Ukrainian stocks and a lack of cooperation on the part of company management.

Denis Matsuvev of Dragon Capital disagrees and regards the PFTS now as a full-fledged stock exchange. "The PFTS is simply like [Russia's] RTS in having evolved from an OTC system. It's an electronic trading system with market makers," he says.

Indeed, organised exchanges are playing a more central role as financial intermediaries expand their market share at the expense of the OTC market.

Even so, although 262 companies are traded on the exchange, the market is still highly concentrated, with the market capitalization of the 10 largest companies representing about 57% of the market. The equity market is highly fragmented, lacks price transparency, and is illiquid. Free float by public companies is estimated at about 4% of market capitalization. It is estimated that some 90% of securities transactions occur outside the organized market

Low liquidity of the Ukrainian market is attributed to minimal transparency, inappropriate political intervention and the concentration of ownership of privatized companies in the hands of Ukraine's six major financial groups.

Reforms needed?

The PFTS might still lack much of the infrastructure of Western-style exchanges, but does it really matter?

"Well, considering that trading volume has increased this year by 100%, it doesn't seem that much of a problem, does it?" retorts Dragon's Matsuvev. Dragon Capital is currently the number-one brokerage on the PFTS.

The Ukrainian government does not agree, and has launched a raft of measures to tighten up regulations and move the exchange towards international best-practice benchmarks. The government has a very direct interest: the planned pension reforms are dependent on pension funds having a stock exchange with high levels of transparency and liquidity to invest in. However, currently pension funds are still in the embryonic stage. In fact, Concorde Capital brokerage believes that, "the [market regulator] has been too progressive in formulating criteria that better suit markets at a more developed stage."

The main shift is towards the "two-tier" listing strategy followed by many emerging markets. The top-tier companies, the strongest, are required to meet international standards of disclosure, leading to investment opportunities, especially for non-state pension funds. Second-tier companies follow less stringent informational requirements, but are nonetheless allowed to obtain the benefits provided by the securities market, for example access to cheaper capital. All other companies are traded with non-listed status.

Listing now requires the issuer's consent. This has caused, as of October 1, the number of stocks officially listed on the stock exchange to shrink to 14. In fact, such is the industrial concentration in Ukraine that just eight stocks make the top tier, and only six the less stringent second-level requirements. But the major reason for stocks failing to achieve listed status has quite simply been that the issuers have not applied for it.

Increased listing stringency is being combined with measures to move towards organized exchanges. According to the new Law on Securities and Stock Market, at least one of the parties in any security trade must be represented by a licensed trader.

Traders must report all trades to the watchdog, the SSMSC, which tracks market statistics on a regular basis. The parties to a transaction through their respective custodians deposit and block with the Interregional Securities Union (MFS, an independent depositary/clearing company) both the securities they expect to sell on PFTS and sufficient funds to pay for the securities they expect to buy. Then the MFS will effect settlement and clearing based on the results of trading and instructions received from the PFTS. In addition, says Klymchuk, "the decision to charge a commission for OTC trades is intended to make exchange trading more attractive."

There are also ongoing plans to establish a central depository. Currently, in another mismatch between government policy and market needs, the National Depositary, set up by the government in 1999, is the only depositary in the country vested with the authority to open foreign correspondent accounts. However, its role in the day-to-day operations of the Ukrainian depositary system is minimal, while the MFS has taken on the role of the country's central depositary and clearing company. The new Central Depository is expected to combine the National Depositary and MFS, but it will need another eight months of fiddling with the details to get it set up.

While the government fiddles, the Ukrainian stock market looks set to keep burning brightly. Despite the global liquidity squeeze and domestic uncertainty, another mammoth increase in trading volume is forecast for 2008.

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