I have been working on the Russian currency market for four years, which is quite a time for a young banking industry in this country. This article is based on the dealing room experience of Bank St Petersburg, one of the leading market operators in the North West of Russia.

The main feature that distinguishes the Russian interbank market is that it is not a single market but consists of many regional markets. The largest of them is the Moscow market. The second largest is in St Petersburg. There are also the Siberian market in Novosibirsk, the Urals market in Ekaterinburg, the Far East market in Vladivostok, and Khabarovsk. The only reason for this situation is the absence of a nation-wide payment system. Instead, we have many regional clearing centres (RKZ), which are not connected on-line with each other.

Why Moscow?

There is an old Russian saying that every power is given by God and every wealth is given by power. Today it is still true. The financial strength of Moscow banks greatly exceeds that of regional banks. According to the rating of Russian banks published by Interfax-Finansy Information Agency on 13 September 1996, 21 of the top positions are occupied by Moscow banks and there are only 38 regional banks out of the top Russian 100.

The Moscow market is the largest and the only true market. Its character very much resembles the international hard currency market. It is also the only place where you can buy a forward US dollar/rouble contract. Alexei Bartuli, Chief Analyst at Interbank Financial House, one of the largest brokerage companies in Russia, says that the daily volume of forwards is approximately the same as the volume of spot deals: US$500 million. The market is totally liquid because of Russian speculators and the constant interest of foreign firms in hedging their rouble profit.

Rouble risk

Two years ago the situation was quite different. The Central Bank of Russia's control over rouble fluctuation at that time was not as tight as it is now, therefore there was a marked interest in hedging instruments. The forward market was booming and many Russian banks actively participated in it. Thus, with the help of American specialists, Bank St Petersburg set up the Research and Development Center for Hedging Strategies. One of the forward dealers who used to work at the Bank is now probably the most authoritative specialist in Russian derivatives in the country.

This booming market was badly bruised on 11 October 1994 (so-called 'Black Tuesday'), when the rouble dropped against the dollar on the Moscow Interbank Currency Exchange by 845 points (from 3,081 to 3,926), and was then ruined by the interbank crisis of August 1995.

Since that time various measures have been taken by the Central Bank of Russia to tighten control over rouble fluctuation. Besides interventions on currency exchanges and interbank market, daily limits of rouble/dollar fluctuation have been introduced.

Russian interbank crisis

It was the first crisis in Russia in the sphere of banking, a very unusual experience for young commercial Russian banks. The origin of the crisis is quite clear: commercial banks, fascinated by the booming interbank deposit market, funded their long-term credits with short-term loans. Nobody cared about credit risks. The banks established foreign exchange and deposit limits on each other on a mutual basis, without a serious analysis of the finances of each other. Moreover, many banks ignored this task altogether and worked without established limits.

Before the crisis, in June/July 1995 US dollar overnight rates reached 20-25 per cent a year. Many banks worked as mediators on the deposit market. Under such circumstances the failure of one bank to pay back could trigger a chain of failures. And this did happen. There was a day when all the participants of the Russian interbank market stopped their payments.

The crises have had a great impact on the interbank market and its participants. Volumes of operations have shrunk drastically. For example, the average daily volume of Bank St Petersburg operations - one of the leading interbank operators in North West Russia - was US$300 million before the crisis. Now it is barely US$50 million.

After the crisis

The banks with big dealing rooms have found themselves in a difficult situation. They are well staffed and equipped, but the number of counterparts available to trade with is too small.

Partially, this problem is being solved with the help of the so-called netting limits. An overall limit of, say, US$1 million is divided into small limits of US$50,000. Such limits can be distributed between small banks with a low rating. A special netting agreement is signed which states that if the losses resulting from a counterpart's open position exceed 85 per cent of the US$50,000 limit, the market-maker bank will close such a position at an available rate. The attractive thing about this is that the risk of the counterpart is sufficiently diminished.

The main problems that Russian banks are facing in estimating counterpart risk are:

• the shortcomings of the Russian accounting system (it is possible to hide bad loans);
• the lack of specialists capable of establishing trading limits and following them;
• that banks are very reluctant to disclose any negative information about themselves and always try to hide it. There is, therefore, a lack of trust among the population in any Russian financial institution. In such situations, a tiny rumour could be a reason for customers to withdraw money from the bank in question;
• cut-throat competition between banks. The banks themselves try to use this unstable situation in their favour and often start disinformation wars;
• the absence of reliable ratings.

Besides these was much speculation about a second banking crisis that could have occurred before the end of 1996.

National peculiarities

The activities of the domestic currency market participants have some specific features. For example, the bulk of hard currency/rouble deals is made in 'today' or 'tomorrow' values, whereas normally hard currency against hard currency is traded with a 'spot' value.

Separate markets provide good opportunities for arbitrage. You can buy cheap dollars for roubles in Moscow and sell them in St Petersburg for five to ten roubles more. But you should think twice before doing this. With dollars, you always have an opportunity to place them either with a Russian or foreign bank overnight, while with domestic currency you may find yourself sitting on a pile of roubles with no chance of earning anything.

Regional markets are not liquid, and the banks, in order to be ready to meet clients' orders, always have to have solid balances on their rouble accounts instead of investing the funds, say, in Russian T-bills (GKO). With the absence of a united national currency market regional banks are exposed to ineffective liquidity management.

Russian banks have invented a method for a quick transfer of rouble funds via the United States payment system: they buy dollars for roubles and sell them for roubles again where they need the roubles. It is a good method when you have to transfer the funds from Moscow to, say, St Petersburg, because you buy cheap Moscow dollars and sell them with a nice margin in St Petersburg. But it is a sure way to lose some money, if you have to do the opposite.

Interbank crisis, and a number of bankruptcies that followed it, was a tough lesson for the Russian banking community. The problem of risk management is now widely recognised as a matter of the utmost importance. The behaviour of market participants has changed drastically. Nowadays, a bid for overnight dollars four to five per cent higher than LIBOR is considered as a warning sign. And many banks have shifted their foreign exchange business to currency exchanges.

What is certain is that if a new crisis comes along, its impact on interbank market participants would not be so devastating as that of the crisis of August 1995.