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The recovery in forward market trading volumes starting from March 2009 was accompanied by a decrease in coverage levels for futures transactions from 10% of the trading volumes in December 2008 to 5% in December 2009, while the options market saw a decrease from 146% to 74% over the same period.

The rapid development of the financial crisis in the stock market starting from August 2008 also brought about a crisis in the repo markets when several major market participants were unable to service their repayment obligations. It was only possible to avoid a systemwide default by involving the Bank of Russia in the settlement process that helped solve the problem of mutual defaults. The crisis was caused by the lack of a guarantee mechanism for the execution of the second stage of repo transactions, i.e. the repayment of funds by the debtor, for repo transactions concluded at MICEX. The financial community in general derived appropriate lessons from this experience; MICEX announced the prospective creation of a transaction execution guarantee system for repo transactions and the transition to a system of transaction settlements using a single clearing agent.

RUSSIAN ECONOMY IN trends and outlooks Source: RTS trading system Fig. 37. Open positions and transaction coverage in the RTS forward market from February 1, to December 31, Risk in repo transactions However, improving the settlement and guarantee systems for repo transactions leaves open the issue of the risks related to excessive development of this market segment. Fig. shows the structure of stock exchange transactions with corporate bonds at MICEX. From early 2005 to August 2008, the share of repo transactions grew rapidly, reaching 84% of the stock exchange trading volume. The crisis in the repo market in September 2008 February 2009 resulted in a significant decrease of this share, however, it started growing again as the market recovered to reach 76% in December 2009. The share of market transactions is only 7%.

The fast growth rates for repo transactions have an economic basis as these transactions are an important instrument of refinancing the banking system by the Bank of Russia and by commercial banks with excess liquidity. However, as previously noted in the comments to Fig. 21, banks tend to use this refinancing mechanism rather aggressively, increasing their investments in bonds in a pyramid scheme fashion by continuously entering into repo transactions. Thus investments in long-term bonds are frequently funded by short-term borrowings.

The increasingly narrowing segment of market transactions with bonds does not allow for the determination of their real market value. For this reason, repo transactions use highly conditional methods of bond valuation. All this increases the systemic risks of investments in rubledenominated bonds that can result in a system-wide default in case of a sudden default by one or a group of major issuers that may be impossible to manage even for a specialized clearing Section Monetary and Budgetary Spheres agent. It may be advisable for the Bank of Russia to consider developing other methods of refinancing the banking system alongside the repo market.

Source: RTS trading system.

Fig. 38. The structure of corporate bond transactions at MICEX (%) Fig. 39 shows data on the evolution of the structure of equity transactions at MICEX.

These also showed a clear trend towards the growing share of repo transactions in 2005-that was briefly interrupted in early 2009 but appeared to have resumed by the end of the year1. The nature of equity repo transactions is significantly different from that of the similar market segment for ruble-denominated bonds. Equity repo transactions are predominantly used by brokerage companies to raise funds for subsequent margin lending to their clients.

The share of repo transactions in the equity market fluctuates between 50% and 66% of the market stock trading volume. In our opinion these levels do not yet represent substantial grounds for risk fears. However, is this share grows, market participants and regulators may need to jointly consider ways of decreasing the dependence of broker margin lending funds on short term borrowings.

The figure for February 2009 is distorted by the inclusion in the overall trading volume of 16 transactions with ordinary shares of Gazprom in the total amount of RUR 1,620,880 million rubles that were erroneously executed by a trader on February 2, 2009, as equity repo transactions and were later ruled invalid following a ruling of the MICEX arbitration committee on February 18, 2009.

RUSSIAN ECONOMY IN trends and outlooks Source: RTS trading system Fig. 39. The structure of equity transactions at MICEX (%) Low capacity of the domestic financial services market For Russian financial intermediaries to be competitive and to be able to provide financial services at a global level, it is necessary for their capitalization, i.e. their net asset value, to approach that of similar international entities. Thus, as of February 8, 2010, the capitalization of nonbank financial holdings in the USA specializing in the provisional Financial Services to the general public, such as Charles Schwab Corp. (SCHW), TD Ameritrade (AMTD) E*Trade Financial Corp. (ETFC), amounted respectively to US$21 billion, US$10 billion, and US$2.8 billion. The major investment fund managers have the following market values:

Prudential Financial Inc. (PRU) that of US$22.5 billion, BlackRock Inc. (BLK) of US$39.billion, Invesco Ltd. (IVZ) of US$8.0 billion, Janus Capital (JNS) of US$2.18 billion. American bank holdings that function primarily as investment banks, such as Goldman Sachs Group Inc. (GS) and Morgan Stanley (MS), have a capitalization of US$83.7 billion and US$37.billion respectively. The market value of US universal banking holdings was US$129 billion for Bank of America Corp. (BAC) and US$91.7 billion for Citigroup Inc. (C).

The majority of Russian Financial intermediaries, except select major banks whose shares are traded at MICEX and RTS, are not publicly traded and do not publish Consolidated Financial accounts. In the apparent understanding that the provision of competitive financial services in the domestic market is impossible without radically changing the operations of brokers, investment banks, managing companies, and other intermediaries, the Russian Federal Financial Markets Service adopted a decision in 2009 to significantly raise the minimum capital requirements for professional securities market participants. A directive by the Russian Federal Financial Markets Service, No. 09-29/- dated July 30, 2009, On amendments Section Monetary and Budgetary Spheres to the capital adequacy ratios for professional securities market participants, investment fund managing companies, Mutual Investment funds, and private pension funds that were previously established by the Federal Financial markets service directive No. 07-50/- dated April 24, 2007, the minimum capital adequacy requirements were raised from RUR 5 million to RUR 35 million starting from July 1, 2010 and to RUR 50 million starting from July 1, 2011 for brokerages; from RUR 10 million to RUR 35 million and RUR 50 million respectively for dealers and securities trust managers, and from RUR 60 million to RUR 80 million starting from July 1, 2011 for collective investment vehicle managing companies.

However, in our opinion, these measures will be inadequate to solve the problems of low capitalization and of the ensuing low efficiency of Russian financial intermediaries. Developing this business segment is seriously hindered by the low capacity of the financial service market in Russia. In other words, the measures taken by the authorities in the areas of pension reform, social support to the public, developing the financial market, etc., will not translate into significant growth in the assets brought by domestic investors to the stock market either at present or in the short term perspective.

Within the subject study of nonbank financial intermediary economics that was taught at the Higher School Of Economics state university in 2009, we sought to estimate the capacity of the Russian financial market in 2009-2014.1 Using various sources and interviews with experts, asset values were estimated for the assets held by various categories of individual and institutional investors in brokerage accounts or transferred into trust management, including investments in mutual funds. The size of the market for investment services was also estimated for the placements of various securities and for conducting merger and acquisition transactions. This was followed by estimating the annual revenues of financial intermediaries from offering these non-banking financial services, which finally enabled the potential business valuation of investment banks, brokerages, and trust managers using a discounted cash flow model. Our estimates show that the business value for financial services providers in Russia is approximately US$6 billion for intermediaries servicing retail investors and US$billion for intermediaries servicing issuers and institutional investors, totalling US$19 billion.

Approximately half of the total capitalisation is taken up by non-resident institutions or their Russian subsidiaries that successfully compete with Russian institutions in servicing high net worth individuals with net asset values in excess of US$1 million and in the investment banking services market for foreign bond placements by Russian corporates, equity IPOs and SPOs, and mergers and acquisitions.

Thus the total business value for Russian investment banks, brokerages, and trust managers is approximately US$10 billion, which prevents the appearance in this market of institutions that could effectively compete with foreign financial institutions. Despite the superficially favorable indicators of market trading volumes, of the capitalization of Russian companies, of IPO and merger and acquisition transaction volumes, the competitiveness of Russian providers of nonbank financial services is questionable not only at present but also in the near future. This per se carries greater risks for investors, issuers, and the economy as a whole. Addressing this challenge will require government authorities and private businesses to make breakthroughs in the areas of strategic management, innovation, incorporating Russian financial institutions into global value chains in international financial markets, and taking deciFor more details, see the study results published in the NAUFOR bulletin, No.3 (March) 2010.

RUSSIAN ECONOMY IN trends and outlooks sions that can have a real impact on significantly increasing the capacity of the domestic financial market.

Despite the gradual recovery in the stock market, unprecedented liquidity indicators and ruble-denominated bond placement volumes in 2009, the inherent risks of the Russian financial market remain, and the market remains vulnerable to both external shocks and internal risk factors.

2.4.6. The prospects of resuming carry trading operations The Russian stock market has two principal external growth drivers: oil prices (see Fig.

28) and short-term foreign capital (see Fig. 34). As shown previously (see Fig. 29), there are fundamental grounds to believe that the oil prices will not grow significantly in the next years. In this case, stock prices will come under increasing pressure from movements in foreign portfolio investments and thus will be increasingly influenced by carry trading strategies.Prior to the crisis, such strategies were a principle growth driver for the banking sector, giving banks cheap funds for onlending and investing in fixed income instruments. The scale of their use is evidenced in Fig. 10 that shows the currency gap between bank assets and liabilities denominated in foreign currency. During the crisis, borrowings from non-residents were replaced by borrowings from the state. However, the Bank of Russia and the Ministry of Finance consistently withdrew from the banking sector in late 2009, once again transitioning from net creditors to net debtors of the banking system (see Fig. 12). Despite the growth of bank deposits, one must bear in mind that such funding is expensive for banks and its use for lending results in a low net interest income margin of 3-5%. For this reason, it is highly likely that the use of carry trading in banking will resume in the post crisis period.

Moreover, banks remain as the principal investors in the ruble-denominated bond market.

As shown in Fig. 20, the rapid growth of transaction volumes in the ruble-denominated corporate bond market from early 2004 to July 2008 was made possible predominantly by the use of carry trading strategies by Russian banks and foreign hedge funds. It is difficult to derive a quantitative estimate of the share of this strategy in the total funding sources for investments in ruble-denominated bonds. For example, Greenwich Associates estimates that hedge funds accounted for 45% of the trading volumes for emerging markets issuer bonds in 2006. At the start of the global financial crisis, mutual mistrust by banks led to the failure of carry trading strategies. To answer the question regarding the timing of its resumption, one must look into the preconditions for its existence. There are three such prerequisites: a drop in the value of the borrowing currency, low interest rates in the country of borrowing, and the existence of a liquid and relatively stable foreign exchange market and of financial assets denominated in national currencies. Fig. 40 shows data for the evolution of oil and gas prices, as well as for the growth of the M2 money supply indicator and of foreign exchange reserves.

These data show that in 2009 the market reached its bottom for all of the above indicators, which was followed by their resumed growth. This provides reasons to believe that Russias The essence of the strategy is straightforward: attracting funds in foreign borrowings in the currency of countries with low interest rates (borrowing currency) for the purpose of this subsequent investment in the financial instruments of countries with relatively the high national currency interest rates (investment currency).

Key findings have been published in The Wall Street Journal on August 30, 2007. See also OECD Financial Markets Trends. Volume 2007/1. No.92, page 42.

Section Monetary and Budgetary Spheres financial condition shall remain stable in the short to medium term, which will have a favorable effect on all the preconditions for the resumption of carry trading.

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