The most exciting derivatives market in Europe at the moment is arguably Russia’s.

Its two domestic exchanges, Moscow Interbank Currency Exchange and the Russian Trading System Stock Exchange, which runs the derivatives market Forts, are complemented by UK-based EDX London.

Generally, futures are traded onshore. Forts, where most futures trading happens, enjoys good liquidity, including from rich individuals and hedge funds.

The options market is largely offshore, where EDX London pumps out between 3m and 3.5m options a month, and has launched its own index.

“Options being traded offshore on EDX is a recent development,” comments Kevin Dougherty, portfolio manager of Pharos Fund, which invests in Russian equities and fixed income. “Most options were traded OTC until the middle to end of 2009. Bringing options on Russian securities on the stock market at EDX was a big step forward.”

Growth powered by Forts

Much of the phenomenal growth in Russia has been powered by Forts. In June 2008, Micex and Forts together recorded 31.6m contracts, of which 8.2m were at Micex. In June 2010, activity had almost doubled to just under 60m contracts, but Micex’s share had shrunk to 3.5m.

As recently as October 2008 Forts and Micex were far more evenly matched in volume. But that November, monthly trading on Micex collapsed, from 14.6m contracts to less than 1.5m. It has struggled to recover.

At the same time, RTS has grown by leaps and bounds. “The main competitive advantage of any exchange is liquidity,” says Evgeny Serdyukov, head of futures and options market business at RTS. “Forts is the most liquid market for Russian assets. Average daily trading volume of Forts is now at $5bn a day.”

RTS keeps innovating

According to some market participants, RTS Index futures are the exchange’s most successful product. “The futures on the RTS index are very liquid on RTS, everything else is not,” says Vladimir Sotskov, head of equity derivatives at Uralsib Capital, who divides his time between Moscow and London.

“The RTS Index Future is the most active and successful product they offer and among the top 10 most liquid contracts in the world,” explains Evgeny Kuteev, managing director of exchange-traded derivatives at Otkritie in London. “And that is despite the fact that it’s inconvenient to trade, as it’s dollar-denominated, while margin requirements are settled in roubles. However, people still trade it because they need access to the market.”

And according to Michael Kart, managing partner at hedge fund Marshall Spectrum, which trades options on EDX and futures on Forts, “There is still a lot of potential for growth in the RTS Index.”

Then in January 2009 RTS Stock Exchange started calculating the RTS Standard Index, based on the 15 most liquid stocks trading on the RTS Standard market. A cash-settled futures contract on this followed in February 2010.

“It is denominated in roubles, which would be better to trade, but it’s based on a different methodology,” says one market participant. “However, it’s not as liquid as the RTS Index Future.”

On the technical side, Forts and RTS Standard have migrated their trading systems to the protocol Plaza II, a step towards consolidating all RTS’s trading, clearing, settlement, statistics and reporting systems on to one platform. The data dissemination and order management systems have moved from MS SQL technology to Plaza II to enhance the performance of Forts’ trading platform and speed up processing.

Meanwhile, RTS has launched unified settlement of Forts equity futures and stocks on RTS Standard. This allows simultaneous execution and netting of liabilities on the two markets. It should make arbitrage cheaper and reduce operational risks.

In July, Forts introduced its fifth FX contract, euro/dollar options. “These are gaining open interest quite fast and that is a sign of the interest coming from real hedgers and not speculators,” says a spokesperson for the bourse.

The newest horse in RTS’s stable is its first open-ended mutual investment index fund, Troika Dialog RTS Standard. RTS believes this is the first step to the formation of ETF analogues in Russia.

Open to all

The exchange takes pride in being open to all kinds of investors, saying “liquidity is accumulated from different resources, which is better for the market”.

The crisis of 2008 only made this advantage more visible. “When foreign participants were trying to understand the situation on the global financial market, private investors became more active and RTS’s turnover started increasing,” the spokesperson says.

Another advantage RTS is proud of is its “close to 24 hour trading”.

Dougherty at Pharos sees significant growth potential for options at Forts. “Some domestic institutions, such as mutual fund managers and pension funds, want to see more options on the domestic market at Forts, as they are not allowed to own offshore funds,” he explains.

Asked if RTS was planning any cooperation with Micex, EDX or other exchanges, Serdyukov replied: “While RTS is the major exchange in Russia and developing rapidly, we are aware that for the next stage of our international growth we will need strategic partners such as other exchanges and trading venues.

“Of course we are in contact with the top 20 exchanges of the world, but it is very early days in terms of concrete cooperation. While we have talked to the Nasdaq group, we are also talking to other international exchanges. We are very open to international partners, but right now we are in talks with our market participants and evaluate their needs, so we expect another six months will pass before we move into the next stage regarding any international cooperation.”

Another market participant said: “I doubt the RTS and EDX will cooperate any time soon. The most likely scenario is that the RTS merges with Micex to form a stronger trading hub in Russia.”

Dougherty believes that the non-convertibility of the rouble would for the moment prevent any meaningful cooperation between either of the domestic exchanges and EDX. “The RTS is unlikely to take any steps to cooperate with a foreign exchange without the government’s direction,” he adds. “I do not see any such moves on the horizon.”

Asked what changes he would like to see in the market, Dougherty says “we would like to see full convertibility of the rouble, which would allow integration in the future”.

A new mood at Micex

Micex is Russia’s biggest stock exchange, claiming to account for 90% of on-exchange share trading by value and 100% of government bond trades.

The Micex Index comprises the 30 biggest and most attractive companies. It is calculated on a tick-by-tick basis and there are dozens of ticks every second. Micex trading system registers up to 850,000 deals a day and can easily be scaled up. Its risk management system is based on the world standard Span technology.

However, as a futures and options exchange Micex was a one trick pony before the financial crisis. When volume in its dollar/rouble contracts collapsed in November 2008, it had nothing to fall back on, and this side of its business has never recovered. The bourse cited “subdued FX and cash market risk appetite” for the slump in its FX and interest rate futures.

Since 2009, however, it has begun gradually to build alternative products – and now it appears to be making headway.

Micex’s futures on single stocks and on the Micex Index hit record trading highs in June. The value of index trades reached $2.7bn, Sberbank futures $250m, Gazprom futures $216m, Norilsk Nickel futures $205m and Lukoil futures $125m. The total number of single stock and index trades almost reached 900,000.

During the last year, Micex has also made some significant changes. In April 2010 it began using a derivatives trading and clearing system based on a 64-digit platform. It can handle the rapidly growing number of transactions, especially by algorithmic trading systems.

Two months later, the bourse introduced its central counterparty clearing house for derivatives and began a new settlement scheme, which made it possible to deliver assets needed for derivatives settlements from spot market accounts.

Since July, Micex has been accepting US dollars as collateral for FX and equity derivatives, removing the need for participants to convert currency. Asked whether Micex was considering the same option for euros, Grigory Gankin, head of the derivatives division, said Micex was “ready to start with this – as soon as we see any interest from the participants”.

Waiting for liquidity

Next in the pipeline is options: on single stocks, the Micex Index and currencies.

Micex is modernising its collateral system and will accept securities as non-cash collateral. Another point of development is its Span-based portfolio margining. The bourse plans to introduce inter-commodity spreads as well as calendar spreads.

Will these efforts change the competitive balance between the three exchanges? “With our new product offering,” Gankin says, “we will likely have to compete more with EDX in the field of deliverable stock options, but less so with RTS, which is specialised in this area on options on futures. Micex will also launch intermarket spreads, a product that RTS doesn’t offer yet.”

All these exertions have earned the bourse respect, if not yet liquidity. “Micex could be interesting to trade on. For some reasons, while they have very good products, they are just not selling. Their technology and procedures are better than Forts, but they’ve failed to attract enough interest so far,” says Kuteev.

Often seen as more domestic than Forts, Micex is now negotiating with one of the major international derivatives exchanges about a cooperation venture, but the would not give further details.

The bourse has also established a special office to promote relations with foreign clients, and is planning a roadshow.

Micex believes more global banks will enter its derivative market, which, combined with new instruments such as stock options, should attract more foreign investors.

Micex’s two year strategic goal is to integrate its derivatives, FX, equity and bond markets and introduce integrated clearing.

In the near term, it plans to introduce a single admission to different segments of the derivatives markets.

The bourse admits that its main challenge is to achieve a leap in derivative trading volumes. But it believes it has a good chance to capitalise on its recent technological and risk management improvements. “We are already facing increased interest from investors and market professionals, including foreign ones,” the bourse says.

Russia in London

Since the launch of its Russian service in December 2006, EDX has hosted the trading of more than $130bn in notional value, representing more than 70m, over 3m a month.

EDX offers options and futures on its own FTSE Russia IOB Index, and options and futures on single depositary receipts from companies such as Lukoil, Gazprom and Rosneft.

The exchange claims to account for around 90% of all Russian stock options trading volume.

Renaissance Capital, Troika Dialog, VTB Capital, Aton, Otkritie, Uralsib and Alfa Capital are the seven Russia-based members out of 25 active members of the Russian service.

Yet EDX does not see itself as a competitor to Forts or Micex. “International companies can only issue 25% of their share capital as depositary receipts the rest would have to be traded domestically – hence EDX doesn’t compete with the Russian bourses for that 25%,” explains David McTurk, exchange broker at EDX London.

Compared to the Russian bourses, EDX has the advantage of simpler membership regulation by UK law rather than Russian regulation, which lags behind in creating an internationally competitive marketplace. A key selling point for EDX is the ease of market access it offers and the ability of Russian clients to trade freely with international counterparts.

Now, it wants “to build on the success of the Russian product and diversify across the emerging markets landscape”.

It is also “working on dividend futures products, as dividends are a liability in Russia – so far, trade in dividend swaps is OTC,” explains Teresa McCarthy, business development manager at EDX London.

Trading in Russian index products outside Russia has struggled to gain traction and the bulk of trading at EDX is in its single stock options. Yet the FTSE Russia IOB, which includes the 15 most liquid Russian companies with GDRs trading on the London Stock Exchange’s International Order Book, has attracted more trading activity over the past year. In the second quarter of 2010 it reached a record of 30,000 contracts with a $1.2bn notional value.

The next stage for EDX

If challengers arise for EDX’s share of the Russian derivatives market, they are most likely to come from outside Russia, and growing interest in emerging markets makes this a question more of “when” than “if”, the bourse admits.

“Overall interest is still gathering pace in emerging markets,” McCarthy says. “Liffe and Eurex have also launched Russian derivatives products, so in terms of competition, other international exchanges are keen to gain a stronger foothold in this market.”

How is EDX responding to this risk? “We’re monitoring the international competition and trying to ensure our clients are happy with the service we’re offering,” says McCarthy. “As we’re a small team and a specialised exchange, we can be flexible and react quickly to client feedback. Having a leaner organisational structure to navigate means we can implement changes quickly.”

While market participants say EDX is very liquid, Sotskov argues that it acts “more like a clearing platform rather than an exchange with an order book”.

Kuteev agrees. “EDX’s main business is OTC trades, which are then cleared through EDX,” he says. “Their main users are investment banks which have no interest in bringing trades on the exchange. They would rather keep the trades on their order books and keep clearing through the exchange. EDX tried to establish DMA, but failed, and their single stock futures have not been successful. They are still facing the challenge of creating enough liquidity for those listed products.”

Three’s company

Despite the unusual market structure of three exchanges, many international investors feel comfortable with it.

Asked who benefits from the current set-up, Dougherty replies: “Those who can trade everywhere, such as us. Options are an integral part of our strategy to hedge positions. If the worst happens we are more comfortable to have our positions offshore in case of another big sell-off, so that is part of our risk management procedure.”

Kart at Marshall Spectrum agrees. “For us, EDX provides the best way to isolate counterparty risk, compared to domestic exchanges. It is also gaining in market share and steadily growing.”

However, Dougherty would like to see more on-exchange trading at EDX, to increase transparency and tighten spreads.

Michael Kart’s wishlist sounds similar: “We anticipate that the greatest challenge for the development of the market is the level of liquidity as well as pricing transparency. We would wish the market to be more transparent and standardised. A real standardised platform for trading options is still lacking. At present, options are largely still traded OTC, where market participants trade only with selected counterparties.”

New sources of demand

All three exchanges are likely to benefit as more pension funds and mutual fund managers come to the market.

“Historically, pension funds were banned from using derivatives,” explains Tamer Amara, partner at Clifford Chance in Moscow. “Now they can invest in derivatives, but there are still severe restrictions in place (such as the requirement for the eligible derivative instruments to be exchange-traded).”

Mutual fund managers were limited to 10% of assets under management, but this cap has now been removed.

“We are looking potentially at a huge new demand,” believes Sotskov at Uralsib. “Some fund managers have been using derivatives, but usually via the management company that used derivatives for offshore funds. Managers of Russia-based mutual funds have been using few derivatives. If they did, they did basic hedging with futures, but no complex transactions or options.”

However, the industry is still in a state of transition. “Neither buy side nor sell side really understand what to do with the new liberties and possibilities,” Sotskov says. “Both sides have to be educated how best to use Russian derivative products.”

Regulatory progress

Removing the limits for pension and mutual funds are just a few recent regulatory steps that have helped the market evolve.

“In terms of listed derivatives, there have been positive developments,” explains Alexander Anichkin, counsel at Clifford Chance. But he highlights some areas needing more work: “Since July 1, 2010, all listed derivatives are going through a CCP. There is no law on netting, and there are hopes that the regulator will tackle this by the end of the year. But so far, this is just a rough draft, so nobody knows when it’ll actually happen.”

Measures due to come out in the foreseeable future, Anichkin says, include further improvements of laws on exchange trading, a law on clearing that could improve the infrastructure, and legislation that removes remaining insecurities, such as the question of what happens to the collateral placed with RTS or Micex in case of their insolvency.

Foreign investors still face obstacles, such as the need for a Russian broker to handle any cross-border transaction. “Russia still has quite a way to go in terms of legal structures to attract more foreign investors,” observes Kuteev. “For example, there are no give-ups. The government is trying their best, but while they are moving in the right direction, it is still going a bit slowly.”

Merger on the cards

However, while the market is growing, government intervention might shake up the balance of exchanges.

“The government has formed a task force charged with improving the investment climate in Russia,” says Amara. “They are looking to improve both the physical infrastructure and the legislation side. What is encouraging is that unlike the situation some time ago, the regulators are now more willing to listen to market participants. In addition, there appears to be a political will behind this initiative, as can be seen by the fact that the head of the task force is Alexander Voloshin, who used to run the presidential administration. You don’t make such a high level appointment without meaning to achieve results.”

This initiative may have wide-ranging implications for both RTS and Micex.

At present, Micex is owned by banks and seen as close to the banking sector, while RTS is backed mainly by broker-dealers.

“A merger between Micex and RTS has been on the regulator’s agenda for quite a while,” says Anichkin. “The authorities are planning to create a regional financial centre by 2020, which would include the merger of the stock exchanges to create a central exchange and a central depository.

“This merger will happen, but there is long way to go,” he affirms. “Surely, no earlier than two years from now. It would create a financially stronger platform and the measure would create strong synergies. Many trades include two different counterparties with two different rulebooks, which is not very convenient at all.”

While a merger might make sense to some and be welcomed by part of the market, the exchanges involved seem reluctant to embrace the idea.

“The potential combination of Micex and RTS is a point of discussion that should be held at the shareholders’ level,” says Gankin.

Forts is even more reserved. Serdyukov highlights the fact that Forts is already cooperating with domestic specialist exchanges like the St Petersburg Exchange and the Moscow Energy Exchange, as well as exchanges in the Ukraine and Kazakhstan.

“There are two trends at work at the moment,” Serdyukov says. “For 10 years, there has been the trend to combine exchanges, and another trend for diversification and specialisation. We think that a market with several competitors is actually healthier, as this will drive competing exchanges to introduce new products and services, which is what customers want.”