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Corporate law and governance, financial transaction taxes

Project Group №1

Financial infrastructure and financial market regulation


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Will Megaregulator Help Create IFC in Moscow?

26.09.2012 16:56 / forbes.ru

To see domestic IPOs by Russian companies, laws must cover derivatives.

Plans for a financial markets megaregulator, the subject of government debate today, are centered around a question: which ministry should serve as the base? A wider interpretation: financial regulation reform is one of the steps toward creating an international financial center (IFC) in Moscow. This objective was set by the Russian government several years ago, before the crisis. And still, Moscow has not turned into a global financial hub. Obviously, one of the prerequisites for that is the return of Russian derivatives trading to the domestic markets. The major part of these transactions, like financial derivaties (totalling hunderds of billions USD per year) takes place in other jurisdictions, offering better climate for investors.

Modernization of financial regulation is only one task among many. A convenien market infrastructure, on par with developed international trading floors is a must, provided this infrastructure is profitable. Building effective court protection and legislative environment (a different long story), offering investors convenient local reporting that includes various instruments and transparent taxation of financial instruments trading. Also, efficient credit risk management such as close-out netting, a set of netting rules in case of cancelled transaction. All of this requires legal amendments.

Certain steps in the right direction are being taken. For instance, since January 2012, the Central Bank has de facto introduced the concept of fair value for derivatives in accounting, harmonizing Russian accounting standards with international practice. This increases the appeal of Russian jurisdiction. Despite most companies and banks reporting by IFRS standards, local regulators mostly use RAS, therefore harmonizing IFRS and RAS is a justified measure.

Still, many issues with complex structured products issues accounting, covered by IFRS (such as derivatives structured in loans and deposits), remain unresolved in Russia. Russian Accounting Standards are unclear on hedge accounting, which in the case of high derivative trading volumes could lead to a temporary loss in profit margin with predictable consequences: the company could be relegated to a lower borrower grade, making loans more expensive.

Another problem is multiple concepts for tax and accounting. RAS uses "fair value", whereas the Tax Code uses "fair price", not applicable to a wide range of derivatives, since it allows variable interpretation and does not comply with market practice. These inconsistencies could lead to an inflated tax burden. If a company actively trades in financial derivatives and reports a negative fair value, which is not deducted from the tax base for the same period, profit turns out low and taxes are high.

Close-out netting is worth a separate mention. In spite of the fact that the Securities Market Act and the Bankruptcy Act allow this credit risk control mechanism since August 2011, it does not work in practice. The reason is there are no repositaries to register OTC trades in compliance with the law. The list of inconsistencies goes on, but one thing is clear: growing competition form other financial centers makes it imperative to move ahead in the right direction and make it fast. Efforst by regulators and market participants should be coordinated to solve this multifaceted problem. Only in this case will another international financial center emerge.

Project Group №1