Lenin be damned. For yield plays look no farther than Russia.

By Margaret Elliott

If Lenin were able to climb out of his refrigerated coffin in Red Square and take a look around the Russian economic scene, he might be tempted to climb back in.

Derivatives and other advanced capitalist tools are making inroads-albeit in a primitive, Wild West sort of way. Owning title to a security can be a dicey legal proposition. Settlement of trades on a set schedule is still unusual, and custodial issues often prevent U.S. investors from entering the market.

Yet the nascent Russian derivatives market is clearly on its way. Investment got a big boost recently when Moody's and S&P revealed new sovereign ratings for the country. The Ba2/BB- from Moody's and S&P, respectively, placed Russia well above Argentina and Brazil in the sovereign crib sheet and just below Mexico.

A variety of international banks and brokers, drawn by the enormous size and yields in the Russian markets, have set up shop and are helping foreigners use derivatives to gain access to a market fraught with perils. The obstacles haven't deterred investors, who have used derivatives to gain access to a quirky market to pick up returns that often average around 50 percent and sometimes enter triple digits.

Lower barriers

Although the inefficiency of the cash markets has limited the development of standard products, the markets are becoming more and more liquid. The Russian government, desperate for foreign cash, has made some major structural improvements to lure external finance into the country. "There's a groundswell among bankers and officials to make investment opportunities more accessible,'' says Nicholas Gordon-Smith, managing director of Credit Suisse Financial Products in London. Gordon-Smith, who is responsible for the firm's emerging markets derivatives, notes that, "The barriers to efficiently functioning markets are well-understood and are getting smaller every day."

The latest change in Russian regulation allows foreigners to invest in GKOs-short-term Russian government bills. But the structure, known as an S (for special) account, is so complex that it almost defeats the purpose.

The S account works as follows: a foreign investor deposits U.S. dollar funds in one of the 22 designated S-account banks (21 Russian; one foreign-CS First Boston). The funds are translated into rubles at the spot rate and invested in GKOs. At the time of the initial purchase, the investor must also purchase a forward contract to convert the GKOs back into dollars in three months. If an investor would like to continue the investment beyond that time, he or she can also purchase an option not to exercise the forward.

The S accounts are a peculiarly Russian approach to the subject. The Russian government wasn't content to facilitiate entry for foreign funds; it had to make sure the exit was open as well. "At least they did something to open up the market," says Robert Devane, head of fixed income at the Moscow broker Troika Dialogue. He estimates that close to $5 billion has poured into the market since it opened in September.

The S account doesn't satisfy all the needs of foreign investors in the Russian money markets. The key problem is that yields on the accounts have been capped by the government since October 16 at 16 percent. With only one foreign institution as yet allowed to hold S accounts, foreigners investing via a Russian bank incur a default risk, though several of the 21 approved banks have good ratings-namely Uneximbank and Vneshtorgbank.

Investors who seek to receive the uncapped domestic yields must resort to so-called gray schemes. A typical scheme may involve a Western company seting up a 100-percent Russian-owned subsidiary and investing in GKOs through this entity. Templeton, the mutual fund company, is thought to have $60 million invested in GKOs in this manner.

Longer-term bonds issued by the Ministry of Finance and known as MinFins are still somewhat inaccessible for foreigners, although GDRs are available on the product. The government is examining ways to allow foreigners to invest more directly in this market, although it isn't clear yet whether the solution will be simpler than the S account.

Stock vehicles

Access to the equity markets in Russia for those unwilling to buy and sell directly comes through a quasi privately placed GDR or ADR. The point of this paper is to give investors an instrument that is as clean as they want of the structural risks involved in investing in Russian equities. Pricing on these certificates is based on how much of the custodial, settlement and currency risk a bank or broker is asked to take on. "This isn't a very interesting product now," says one investment banker. "If we eliminated all the risk for an investor, then it would be just the same as a LIBOR-based deposit. But some U.S. mutual funds continue to use these vehicles because they are prohibited from investing directly."

More sophisticated access strategies to both the equity and MinFin markets are being offered by foreign banks with primary-dealer status like CS First Boston, Citibank and ING. Investors can enter into a total return swap or repo on a MinFin security. They can also do total return swaps and repos on equities. These structures can be set up to protect the investor from currency, custodial or settlement risks, and may be cheaper to own than a certificate or a GDR.

It is too early for standard-issue derivatives structures. The only exception is the area of forward contracts on rubles, which is well-developed, for obvious reasons, and is settled via a contract of differences in a sophisticated manner. Interest rate futures and forwards and currency futures are available in small amounts over the counter, but the growth of this activity is constrained by the inconsistent liquidity of the underlying cash markets.

As Russia hurtles toward a more sophisticated capital market, the Ministry of Finance clearly wants to promote the development of exchange-traded derivative products. To this end, many of the regional exchanges in far-flung corners have one or two illiquid contracts.

At the Moscow Interbank Currency Exchange (MICEX), which is the best developed and most reliable of the Russian exchanges, GKOs and rubles are traded electronically, and contracts for U.S. dollar futures and GKO futures have recently been launched. Only locals can trade these contracts, and it is essentially an interbank market to which primary dealers have access. Volume and liquidity, moreover, remain negligible. Yet Troika Dialogue's Devane notes that foreign banks operate as primary dealers on MICEX, and he believes "this is the effort most likely to succeed."

An investment banker notes that "There is a credit risk or liquidity constraint involved in dealing on all Russian exchanges, but MICEX is a large liquid exchange." A key factor to remember, says Gordon-Smith, is that "Derivatives are a luxury. For most companies in Russia, just getting the funding is the problem. Whether it comes in dollars or francs doesn't matter to them." In the mean time, it seems, derivatives players hungry for more elaborate plays will have to bide their time and wait patiently for the maturation of the Russian cash markets.