## Box 1: Establishment of the CSD and Introduction of Foreign Nominee

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### Background and problem prior to CSD establishment
- Foreign investors and global custodians viewed Russian law as not guaranteeing that an account at the NSD would be equivalent to an account at the registrar, leading investors or their global custodians to bypass the NSD and deal directly with the registrar, creating inefficiency and higher costs.
- The NSD’s legal status was not qualified as an “eligible securities depository” under the Rule 17f-7 of the U.S. Investment Company Act.
- In principle, Rule 17f-7 implies that the fund manager makes his own judgement on whether a particular settlement infrastructure complies with the rule; in practice this judgement is made with the assistance of the investor’s global custodians.

### Concerns raised by the Association of Global Custodians (AGC)
- AGC-identified obstacles to acceptance of the NSD:
  - The NSD did not have a legislation-based CSD mandate; it was not officially called a CSD by the government.
  - The NSD did not have a CSD license and therefore did not follow any formal set of rules keeping its activity within defined boundaries.
  - The NSD had not proved that keeping accounts at the NSD is legally as safe as keeping accounts at the registrar of a stock.
- Implied legal needs:
  - Create a legal concept of the “Central Securities Depository” in law.
  - Empower CSD records to have higher priority than the registrar’s records (with a few exceptions).
  - Assign formal CSD status to the NSD.

### Legislative and institutional changes (dates and actions)
- On December 7, 2011 the law “On the Central Securities Depository” was signed.
- The law came into force on January 1, 2013.
- The status of the Central Securities Depository was assigned to the NSD on November 6 2012, making it the only CSD in Russia (even though Rule 17f-7 does not explicitly require uniqueness of a CSD in one country).

### Introduction of the foreign nominee framework
- The “satellite law” introduced the foreign nominee concept with these allowances and restrictions:
  - ICSDs and national CSDs are allowed to open nominee accounts at the NSD.
  - The satellite law gives global custodians an option to open accounts at ICSDs.
  - Global custodians are not allowed to open nominee accounts at the NSD.

### Implementation outcomes and market-related developments
- Government motivation and liberalization drivers:
  - Ministry of Finance’s stronger voice in liberalization as its borrowing needs increased since 2009.
  - High global demand for EM LCY bonds after the GFC presenting a potential funding source.
- Operational milestones:
  - Starting from February 7, 2013, Euroclear was fully capable of performing post-trade processing of OTC OFZ bond transactions in the liberalized infrastructure.
  - One year later, foreign investors’ access to stock and corporate bond markets was liberalized.
- Market anticipation and positioning:
  - Since late-2011, trading ideas based on expected lower OFZ yields driven by potential foreign inflows were widely cited by analysts.
  - As of end-2011, foreign holdings of cash OFZ bonds amounted to RUB107 billion.

### Foreign participation and scale of inflows
- Foreign holdings and potential inflows:
  - Foreign holdings were initially about 3.7 percent of the total outstanding stock and 5.9 percent of the stock of fixed-rate bullet bonds.
  - Reaching 15–20 percent of ownership (typical in other EMs) would imply an inflow of RUB400–600 billion.
  - Benchmark-driven funds alone could contribute about RUB300 billion additional holdings if the full amount were allocated based on Russia’s weight in GBI-EM indices (about 9 percent) and the total AUM benchmarked to indices as of end-2011 (about US$150 billion).
  - Direct foreign holdings of OFZ bonds increased fivefold in 2012 alone, and their share increased to 20 percent at end-2012.

### Market infrastructure liberalization and instruments
- Effects on instruments and spreads:
  - Introduction of ICSDs allowed foreign investors to switch from proxy instruments to direct holding; issuance of CLNs backed by cash holdings of OFZ bonds virtually disappeared after March 2013.
  - Liquidity of XCCY-swaps was overtaken by that of OFZ bonds since late 2012.
  - The spread between offshore and onshore instruments tightened as liberalization progressed; yields on a ruble-denominated government Eurobond (maturity–March 10, 2018, coupon–7.85 percent) and an OFZ bond (maturity–March 15, 2018, coupon-7.5 percent) converged.
  - Improved price discovery resulted from removing infrastructure and legal impediments, allowing the OFZ bond market to accommodate different types of risk-takers.

### Market liquidity and trading metrics
- JPMorgan’s estimations and trading metrics:
  - The bid-ask spread halved to 5 basis points in 2013.
  - Average trading size increased from RUB20 million in 2011 to RUB50 million in 2012 and doubled to RUB100 million in 2013.
  - Frequency of transactions in OTC markets increased after ICSDs started to operate, as investors could settle trades via ICSDs without involving the MOEX.

### Investor composition and market-making
- Changes in market participation:
  - Foreigners and GIB-subs became dominant market participants in OFZ trading.
  - GIB-subs’ share in the combined turnover of top-50 operators increased from 25–30 percent to 55–60 percent in 2012H1–2013H1.
  - GIB-subs and foreigners represented half of the total OFZ turnover, while their involvement in domestic corporate and regional bonds was negligible.
  - GIB-subs preemptively increased holdings in 2012 to bet on expected yield compression or to form cash OFZ positions for use as underlying assets for CLNs and TRSs.
  - Predominant foreign interest in OFZ bonds caused decoupling from other domestic fixed-income segments and contributed to increased spreads of local bonds to OFZ bonds as liberalization proceeded.

### Market resilience to shocks and investor behavior
- Taper tantrum—May 2013:
  - Foreign sell-off led to a spike in secondary market turnover and impacted medium- and long-term segments most strongly.
  - In the 10–15Y segment, foreign share in actively traded OFZ bonds was 73 percent at end-May 2013.
  - Foreign sell-off was largely absorbed by domestic banks; longer-term segments recovered quickly while medium-term segments recovered more slowly.
- Third round of sanctions—Summer 2014:
  - Sanctions constrained large state-affiliated corporates’ and banks’ access to global U.S. dollar financing, intensifying foreign sales of OFZ bonds.
  - Emergency policy rate hike from 10.5 percent to 17 percent on December 16, 2014 helped stabilize the market and shifted foreign positions from short to long (evidenced by USDRUB futures net position changes).
  - Repricing of OFZ bonds completed within two days: yields shot to 16–18 percent on the first day before declining to more stable levels.
  - The shock did not lead to notable outflows of foreign holdings or big panic sell-offs in daily/monthly trading volumes.
- Rating downgrade—Early 2015:
  - S&P and Moody’s downgraded Russia from investment grade to speculative in January–February 2015; investors with IG mandates had to close positions.
  - AUM benchmarked to the GBI-EM Global Diversified IG-only index was about US$5–7 billion in December 2014, compared with almost US$200 billion for the GBI-EM Global Diversified index, implying limited scale of IG-only-constrained positions.

### Product innovation and issuance response
- MOF responses and issuance mix in 2015:
  - Issued floating-rate bonds ("floaters") and inflation-linked bonds ("linkers") in 2015 with considerable demand.
  - Gross placements in 2015 were dominated by new instruments.
  - MOF issued RUB1 billion of floaters directly to the Deposit Insurance Agency to be later used for capital injection to under-capitalized banks.
- Structure of 2015 gross issuance of OFZ bonds (in billions of ruble):
  - Fixed rate: 294
  - Floating rate: 346
  - Inflation linked: 64
- Inflation-linked bonds offered a real yield among the highest across EMs, making them attractive to investors though costly for the government.
- Floating-rate bonds referenced 6-month average of the RUONIA index in 2015, allowing banks a stable margin over floating funding costs and enabling issuance in turbulent markets.

### Dynamics of returns and investor tolerance
- For OFZ investors, FX movements play a dominant role in total returns for a high-beta commodity currency like the ruble; thus, currency moves can eclipse credit-event impacts on total return.
- Return components (trailing 12-month) for GBI-EM GD Russia included capital gains/losses, accrued interest, and FX revaluation.

### Conclusions and lessons for EMs
- Liberalization integrated the OFZ bond market into the global financial system, enhancing growth, price discovery, and resource allocation while exposing the market to global shocks.
- Gradual market opening combined with institutional and policy framework improvements can help monitor foreign investor behavior, prepare for shocks, and deepen domestic financial market development.
- Even with closed capital accounts or infrastructures, attractive EM domestic assets can draw foreign investors via circumvention; thus policy sequencing around liberalization and resilience-building matters.

*Source: wp1728 - Box 1: Establishment of the CSD and Introduction of Foreign Nominee*

### Box 1: Establishment of the CSD and Introduction of Foreign Nominee

### Box 1: Establishment of the CSD and Introduction of Foreign Nominee

### Background and problem prior to CSD establishment
- Foreign investors and global custodians viewed Russian law as not guaranteeing that an account at the NSD would be equivalent to an account at the registrar.
- This view led investors or their global custodians to bypass the NSD and deal directly with the registrar, creating inefficiency and higher costs.
- The NSD’s legal status was not qualified as an “eligible securities depository” under the Rule 17f-7 of the U.S. Investment Company Act (https://www.nsd.ru/en/about/interact/rule_17f_7/).
- In principle, Rule 17f-7 implies that the fund manager makes his own judgement on whether a particular settlement infrastructure complies with the rule; in practice this judgement is made with the assistance of the investor’s global custodians.

### Concerns raised by the Association of Global Custodians (AGC)
- The AGC identified specific concerns that hindered acceptance of the NSD:
  - The NSD did not have a legislation-based CSD mandate; it was not officially called a CSD by the government.
  - The NSD did not have a CSD license and therefore did not follow any formal set of rules keeping its activity within defined boundaries.
  - The NSD had not proved that keeping accounts at the NSD is legally as safe as keeping accounts at the registrar of a stock.
- These concerns implied that Russia needed to:
  - Create a legal concept of the “Central Securities Depository” in law.
  - Empower CSD records to have higher priority than the registrar’s records (with a few exceptions).
  - Assign formal CSD status to the NSD.

### Legislative and institutional changes (dates and actions)
- On December 7, 2011 the law “On the Central Securities Depository” was signed.
- The law came into force on January 1, 2013.
- The status of the Central Securities Depository was assigned to the NSD on November 6 2012, making it the only CSD in Russia (even though Rule 17f-7 does not explicitly require uniqueness of a CSD in one country).

### Introduction of the foreign nominee framework
- A “satellite law” introduced the foreign nominee concept with the following allowances and restrictions:
  - ICSDs and national CSDs are allowed to open nominee accounts at the NSD.
  - The satellite law gives global custodians an option to open accounts at ICSDs.
  - Global custodians are not allowed to open nominee accounts at the NSD.

### Implementation outcomes and market-related developments
- The government pursued liberalization despite AGC concerns, motivated by:
  - The Ministry of Finance’s stronger voice in liberalization as its borrowing needs increased since 2009.
  - High global demand for EM LCY bonds after the GFC presenting a potential funding source.
- The government removed impediments and made Russia’s infrastructure among the most convenient in EM LCY government bond markets.
- Specific operational milestone:
  - Starting from February 7, 2013, Euroclear was fully capable of performing post-trade processing of OTC OFZ bond transactions in the liberalized infrastructure.
  - One year later, foreign investors’ access to stock and corporate bond markets was liberalized.
- Market anticipation and positioning:
  - Since late-2011, after liberalization became likely, trading ideas based on expected lower OFZ yields driven by potential foreign inflows were widely cited by analysts (Credit Suisse, 2012).
  - As of end-2011, foreign holdings of cash OFZ bonds amounted to RUB107 billion.

*Source: wp1728 - Box 1: Establishment of the CSD and Introduction of Foreign Nominee*

### 3.7 percent of the total outstanding stock

### wp1728 - 3.7 percent of the total outstanding stock

### Foreign participation and scale of inflows
- Foreign holdings were initially about 3.7 percent of the total outstanding stock and 5.9 percent of the stock of fixed-rate bullet bonds.
- Reaching 15–20 percent of ownership (typical in other EMs) would imply an inflow of RUB400–600 billion.
- Benchmark-driven funds alone could contribute about RUB300 billion additional holdings if the full amount were allocated based on Russia’s weight in GBI-EM indices (about 9 percent) and the total AUM benchmarked to indices as of end-2011 (about US$150 billion).
- Direct foreign holdings of OFZ bonds increased fivefold in 2012 alone, and their share increased to 20 percent at end-2012.

### Market infrastructure liberalization and instruments
- Introduction of ICSDs allowed foreign investors to switch from proxy instruments to direct holding; issuance of CLNs backed by cash holdings of OFZ bonds virtually disappeared after March 2013.
- Liquidity of XCCY-swaps was overtaken by that of OFZ bonds since late 2012.
- The spread between offshore and onshore instruments tightened as liberalization progressed; yields on a ruble-denominated government Eurobond (maturity–March 10, 2018, coupon–7.85 percent) and an OFZ bond (maturity–March 15, 2018, coupon-7.5 percent) converged.
- Improved price discovery resulted from removing infrastructure and legal impediments, allowing the OFZ bond market to accommodate different types of risk-takers.

### Market liquidity and trading metrics
- According to JPMorgan’s estimations, the bid-ask spread halved to 5 basis points in 2013.
- Average trading size increased from RUB20 million in 2011 to RUB50 million in 2012 and doubled to RUB100 million in 2013.
- Frequency of transactions in OTC markets increased after ICSDs started to operate, as investors could settle trades via ICSDs without involving the MOEX.

### Investor composition and market-making
- Foreigners and GIB-subs became dominant market participants in OFZ trading:
  - GIB-subs’ share in the combined turnover of top-50 operators increased from 25–30 percent to 55–60 percent in 2012H1–2013H1.
  - GIB-subs and foreigners represented half of the total OFZ turnover, while their involvement in domestic corporate and regional bonds was negligible.
- GIB-subs preemptively increased holdings in 2012 to bet on expected yield compression or to form cash OFZ positions for use as underlying assets for CLNs and TRSs.
- The predominant foreign interest in OFZ bonds caused decoupling from other domestic fixed-income segments and contributed to increased spreads of local bonds to OFZ bonds as liberalization proceeded.

### Market resilience to shocks and investor behavior
- Even after liberalization, OFZ bond market showed resilience in several shocks:
  - Taper tantrum—May 2013:
    - Foreign sell-off led to a spike in secondary market turnover and impacted medium- and long-term segments most strongly.
    - In the 10–15Y segment, foreign share in actively traded OFZ bonds was 73 percent at end-May 2013.
    - Foreign sell-off was largely absorbed by domestic banks; longer-term segments recovered quickly while medium-term segments recovered more slowly.
  - Third round of sanctions—Summer 2014:
    - Sanctions constrained large state-affiliated corporates’ and banks’ access to global U.S. dollar financing, intensifying foreign sales of OFZ bonds.
    - Emergency policy rate hike from 10.5 percent to 17 percent on December 16, 2014 helped stabilize the market and shifted foreign positions from short to long (evidenced by USDRUB futures net position changes).
    - Repricing of OFZ bonds completed within two days: yields shot to 16–18 percent on the first day before declining to more stable levels.
    - The shock did not lead to notable outflows of foreign holdings or big panic sell-offs in daily/monthly trading volumes.
  - Rating downgrade—Early 2015:
    - S&P and Moody’s downgraded Russia from investment grade to speculative in January–February 2015; investors with IG mandates had to close positions.
    - AUM benchmarked to the GBI-EM Global Diversified IG-only index was about US$5–7 billion in December 2014, compared with almost US$200 billion for the GBI-EM Global Diversified index, implying limited scale of IG-only-constrained positions.

### Product innovation and issuance response
- The MOF introduced new types of OFZ bonds in response to investor demand:
  - Issued floating-rate bonds ("floaters") and inflation-linked bonds ("linkers") in 2015 with considerable demand.
  - Gross placements in 2015 were dominated by new instruments.
  - MOF issued RUB1 billion of floaters directly to the Deposit Insurance Agency to be later used for capital injection to under-capitalized banks.
- Structure of 2015 gross issuance of OFZ bonds (in billions of ruble):
  - Fixed rate: 294
  - Floating rate: 346
  - Inflation linked: 64
- Inflation-linked bonds offered a real yield among the highest across EMs, making them attractive to investors though costly for the government.
- Floating-rate bonds referenced 6-month average of the RUONIA index in 2015, allowing banks a stable margin over floating funding costs and enabling issuance in turbulent markets.

### Dynamics of returns and investor tolerance
- For OFZ investors, FX movements play a dominant role in total returns for a high-beta commodity currency like the ruble; thus, currency moves can eclipse credit-event impacts on total return.
- Return components (trailing 12-month) for GBI-EM GD Russia included capital gains/losses, accrued interest, and FX revaluation.

### Conclusions and lessons for EMs
- Liberalization integrated the OFZ bond market into the global financial system, enhancing growth, price discovery, and resource allocation while exposing the market to global shocks.
- Gradual market opening combined with institutional and policy framework improvements can help monitor foreign investor behavior, prepare for shocks, and deepen domestic financial market development.
- Even with closed capital accounts or infrastructures, attractive EM domestic assets can draw foreign investors via circumvention; thus policy sequencing around liberalization and resilience-building matters.

*Source: wp1728 - 3.7 percent of the total outstanding stock (IMF working paper content provided).*

### References

### References

### Academic and IMF working papers
- Ahmed, Shaghil, and Andrei Zlate, 2013, “Capital Flows to Emerging Market Economies: A Brave New World?” International Finance Discussion Papers, Board of Governors of the Federal Reserve System, Number 1081.
- Arslanalp, Serkan and Takahiro Tsuda, 2012, “Tracking Global Demand for Advanced Economy Sovereign Debt,” IMF Working Paper 12/284 (Washington: International Monetary Fund).
- Arslanalp, Serkan and Takahiro Tsuda, 2015, “Emerging Market Portfolio Flows: The Role of Benchmark-Driven Investors,” IMF Working Paper 15/263 (Washington: International Monetary Fund).
- Comelli, Fabio, 2012, “Emerging Market Sovereign Bond Spreads: Estimation and Back-testing,” IMF Working Paper 12/212 (Washington: International Monetary Fund).
- Csonto, Balazs and Iryna Ivaschenko, 2013, “Determinants of Sovereign Bond Spreads in Emerging Markets: Local Fundamentals and Global Factors vs. Ever-Changing Misalignments,” IMF Working Paper 13/164 (Washington: International Monetary Fund).
- Jaramillo, Laura and Anke Weber, 2012, “Bond Yields in Emerging Economies: It Matters What State You Are In,” IMF Working Paper 12/198 (Washington: International Monetary Fund).
- Sahay, Ratna, Vivek Arora, Thanos Arvanitis, Hamid Faruqee, Papa N'Diaye, Tommaso Mancini-Griffoli, and an IMF Team, 2014, “Emerging Market Volatility: Lessons From The Taper Tantrum,” IMF Staff Discussion Note No. 14/09.
- Raddatz, Claudio, Sergio Schmukler, and Tomάs. Williams, 2015, “International Asset Allocations and Capital Flows: The Benchmark Effect,” HKIMR Working Paper No. 04/2015.
- Sienaert, Alex, 2012, “Foreign Investment in Local Currency Bonds: Considerations for Emerging Market Public Debt Managers,” World Bank Policy Research Working Papers No. 6284.
- Noel, Michel, Zeynep Kantur, Evgeny Krasnov, and Sue Rutledge, 2006, “Development of Capital Markets and Institutional Investors in Russia,” World Bank Working Paper No.87 2006.
- Ebeke, Christian and Yinqiu Lu, 2015, “Emerging Market Local Currency Bond Yields and Foreign Holdings—a Fortune or Misfortune?” Journal of International Money and Finance, 59 (2015), 203-219.

### Russia-focused studies, reports, and working papers
- Drobyshevskiy, Segery, Lugovoy Oleg, Ekaterina Astafieva, and Natalia Burkova, 2009, “Modeling the term structure of interest rates on Russian government bonds in 2000–2008,” Institute of the Economy in Transition, Working Paper, Mosco, Russia, 2009.
- Gurvich, Evsey, Vladimir Sokolov, and Alexey Ulyukaev, 2009, “Analysis of the Relationship Between the Exchange Rate Policy of the Russian Central Bank and the Interest Rates: Uncovered and Covered Parity”, Journal of the New Economic Association, 1-2, 2009.
- Ministry Of Finance Of The Russian Federation, 2011, “Public Debt Management Policy Of The Russian Federation For 2012 – 2014,” Moscow, Russia, 2011.
- Yudaeva, Ksenia, Nadezhda Ivanova, Konstantin Kozlov, and Marina Kamenskih, 2009, “The Dynamics of Lending to a Shrinking Economy: the Credit Crunch and the Fall in Demand for Loans?” SBERBANK, Moscow, 2009.
- Deryugina, Elena, Olga Kovalenko, Irina Pantina, and Alexey Ponomarenko, 2015, “Disentangling Loan Demand and Supply Shocks in Russia,” Central Bank of Russia, Moscow, 2015.
- NAUFOR, 2014, “Russian Securities Market: 2014,” NAUFOR, 2014.
- Gazprobank, 2014, “RUB-denominated Corporate Bonds: What Foreigners will Get?” Gazprombank, January 2014.
- BCS, 2014, “OFZ: Foreigners prefer longer bonds”, BrokerCreditService, May-2014.
- Credit Suisse, 2012, “Russia: A New Era for the Local Bond Market,” March 9, 2012.
- JPMorgan, 2014a, “Russia: Searching Through the Ruble,” October 31, 2014.
- JPMorgan, 2014c, “Russia: Special report,” December 18, 2014.
- Reuters, 2012, “Foreign investors rushed for Russian government bonds,” Reuters, February 9, 2012.
- Forbes, 2011, “MICEX and RTS Shareholders have Signed a Letter of Intent,” Forbes, February 3, 2011.
- Euromoney, 2012, “SocGén Urges Investors to Hop on RUB Bandwagon; Liberalization a Game Changer,” Euromoney, October 25, 2012.
- Gazprobank, 2014, “RUB-denominated Corporate Bonds: What Foreigners will Get?” Gazprombank, January 2014.

### Market analyses, industry reports, and bank notes
- JPMorgan, 2013, “Great Rotation: Myth or Reality?” November 4, 2013.
- JPMorgan, 2014b, “Emerging Markets Corporate Outlook and Strategy,” November 26, 2014.
- Standard Chartered, 2013, “Local Markets Compendium 2013.”
- Miyajima, Ken and Ilhyock Shim, 2014, “Asset Managers in Emerging Market Economies,” BIS Quarterly Review, September, 2014.

### IMF and other institutional publications
- International Monetary Fund, 2012, “Global Financial Stability Report: Restoring Confidence and Progressing on Reforms,” October 2012 (Washington: International Monetary Fund).

*wp1728 - References*

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_Source: https://www.imf.org/-/media/files/publications/wp/wp1728.pdf_