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. Last Updated: 07/27/2016

The Veksel Dance

Investors looking for a lucrative new corner of the Russian market have fixed on high-risk, high-yield, unregulated IOU notes called veksels. Are they too risky to touch, or the beginning of a regulated Russian corporate debt market? Erin Arvedlund reports.

For those investors who missed the triple-figure interest rates on Russian government T-bills last year and triple-digit growth on Russian blue-chip stocks earlier this year, the Russian market offers yet another wild and potentially lucrative investment opportunity: veksels.

Detractors call it a market in Monopoly money.

But its proponents -- traders with cool nerves, crack research departments and the right contacts in the banking world -- have been profiting in a booming market where top yearly yields reach 60 to 80 percent.

The International Monetary Fund hates them. Russia's Central Bank tolerates them. But with an estimated $12 billion to $15 billion dollars worth of veksels circulating in Russia, no one in the financial community can afford to take them lightly.

A veksel is, in essence, an IOU. The Russian version, a short-term, unregulated note promising the bearer payment in either cash or goods, can be issued by anyone, making it an incredibly democratic -- and perilously risky -- instrument.

Veksel trade started as a way to clear debts between enterprises that didn't have access to real money, but more fiscally secure companies are now issuing veksels as a way to borrow money domestically. A booming secondary market in these instruments has sprung up, and fixed-income traders are looking to veksels to bring in the sort of high yields that are no longer offered in other spheres of the debt market.

State treasury bills, or GKOs, promised astronomical 200 percent yields in the summer of 1996, but the Russian government is now borrowing at a more modest rate of around 18 percent yearly.

Veksels, meanwhile, are paying off much more handsomely. The benchmark Gazprom veksel yields 25 percent in rubles yearly. Oil giant LUKoil veksels yield roughly 30 percent, while returns on veksels issued by oil major Sidanco and diamond miner Almazy Rossii-Sakha, or ARS, are hovering around 60 percent this month.

"The returns are analogous to U.S. junk bonds of the 1980s," said Daniel Matthews, a securities lawyer with Baker & McKenzie in Moscow. "People threw out all the rules given the risk, because the returns were phenomenal."

Veksel dealers and market watchers express hope that the veksel market is an interim step toward a regulated market in corporate and bank debt.

Moscow brokerage Renaissance Capital released a detailed report last week on the veksel market -- "Russian Veksels -- Interim Investment Opportunity as a Russian Corporate Debt Market Emerges." The title alone bills the instruments as a halfway house on the way toward a more stable system of corporate borrowing.

But for now, the unique market in these informal IOUs is wild and wooly -- and, for some players, quite lucrative.

"We really don't have any such thing in the West, something that's in lieu of currency," said attorney Bruce Bean of Coudert Brothers in Moscow. "But there are going to be millions and millions of dollars made dealing in these things."

The word veksel derives from the German wechsel, which roughly translates as a bill of exchange. In the 19th century in Russia, the term referred to trade receivables as the country's commerce with Europe expanded.

"As the Russians say, every new thing is some old thing that should be well forgotten," noted Peter Malyshev, a securities attorney with Baker & McKenzie.

Veksels were widely used until the 1917 Revolution, but except for some foreign trade applications they died away during Soviet times. After free-market reforms were set in motion, veksels made a comeback, and in late 1995 their use exploded: The post-communist government had tightened Russia's money supply in an effort to rein in runaway inflation, and Russian banks were too busy investing in lucrative government bonds to lend to ailing companies.

With little cash in the till, companies began to issue each other IOUs to cover their debts.

Lenin Widget Factory, for example, would issue a promissory note to a local raw materials supplier to cover its bills. That company, in turn, would use the cash surrogate to pay the local utility, which might turn around and use it to pay the tax authorities.

Veksels evolved into a sort of second currency, with some payable in cash -- if there was any in the widget factory's accounts by redemption date -- or more often, payable in widgets.

Veksels originally issued as short-term promissory notes began passing through more and more hands, serving as a way of effecting payments in an increasingly barter-based economy.

"It was simply unstoppable," said Gleb Shestakov, managing director at Global Fund Management.

Soon top Russian banks jumped into the game. By the summer of 1996 Tveruniversalbank, then Russia's 17th-largest bank, had issued an estimated 800 billion rubles ($135 million) worth of veksels, in a pyramid that collapsed when the bank couldn't place more veksels fast enough to redeem those coming due.

In every corner of the economy, someone was issuing veksels, and three main types emerged: corporate, bank and regional veksels (See "Three Common Veksel Schemes," right).

For a while, only insiders in these veksel circles were buying. But this year, as yields on Russian treasury bills, or GKOs, are expected to fall to 12 percent, the murky veksel market is beginning looking like a gold mine to investors looking for exposure to Russian debt.

Yield-hungry debt investors couldn't resist veksels issued by middle- and lower-tier banks, for example, with returns averaging 23 to 24 percent and 30 to 35 percent, respectively.

"Those veksels are quite risky because the lowest-tier bank is a much more risky place to buy," said Alexander Klimanov, an associate on the veksel desk at Renaissance Capital Group.

Risky, indeed. Legally, veksels exist in a no man's land, and veksel holders have little recourse in Russian courts if the issuer defaults.

"A veksel is basically an unconditional promise to pay, with a signature, a date and that's it. It can be on anything," said Shestakov of Global Fund Management. "Veksels weren't a security, they didn't need to be registered and were governed by an international law. That's why they've been such a loophole."

Shestakov said that veksels were regulated by the arcane Geneva Convention of 1930, which governs promissory notes in signatory countries and superseded Russian law. This, he pointed out, gave veksel-holders spotty recourse in Russian courts.

But on March 11, President Boris Yeltsin signed Federal Law 937, which updates the civil code to classify veksels as a security and technically brings them under the umbrella of Russian securities legislation. However, lawyers note, there is little court precedent yet in applying the legislation to veksels.

Given veksels' highly unregulated nature, buyers must be hypervigilant.

"It takes an incredible amount of effort to identify the validity of a veksel," said a fixed income analyst with Troika Dialog. "They can be faked, or stolen, and even if you buy such a veksel and then sell it, you still may have some responsibility on this veksel."

Despite the inherent risks, there are plenty of buyers.

"The same sort of investors who two years ago bought GKOs are buying veksels now," said one Moscow trader. "And how dangerous was that?"

There is some preliminary interest among foreigners who want to establish investment funds trading in veksels, according to Michael Workman, the chief author of the Renaissance report.

"Probably aggressive investors and hedge funds would be interested in veksels," said Sergei Kashlenko, fixed income analyst at CS First Boston.

Traders in this unique form of paper should make sure, before they begin, that they will be able to redeem them. More likely than not, this means having friends in the right places -- such as on the inside of a large Russian bank.

Redemption can be "unpleasant," according to one debt fund manager. One section of the Renaissance report, titled "A Brief Checklist to Corporate Veksel Selection," reads like a how-to manual for a loan shark: "Survey sources of pressure which could be used against a particular corporate veksel issuer. Certain banks ... will get priority attention when cash is difficult to obtain," the report advises. "Such subtle pressure will be a much more effective recourse ... than resorting to the inefficient and cumbersome judicial system."

Industry watchers agree that having a bank that can knock on a company's door to collect can mean the difference between a good investment and a financial black hole.

"If [Uneximbank sister institution] MFK bank buys a veksel of any company, they can take it back on redemption day and say 'We're Uneximbank, we have your debt, and we're ready to be paid back,'" said one Moscow-based debt trader. "If you have a bank like that behind you, you're fine."

So who makes money on veksels? Banks come out on top in veksel dealings, earning interest on the veksel and, in some cases, returns from investments made while the veksel's principal lies in the bank's account.

Brokers, too, make out handsomely with commissions each time the veksels change hands on the way back to the original issuer.

But not everyone is a winner in the veksel dance.

"Everybody gets a profit, except the little guy who sold the goods and never gets paid," said one fixed-income trader, who asked not to be identified.

And in the larger sense, "a culture of political dependence is maintained among the big banks," notes the Renaissance report. "Money is not made through prudent lending decisions, but by lobbying public officials for access to guarantees, inside privatization deals and poorly monitored use of public funds."

Even more damaging is the drag on the economy, the report says: Lending without proper credit assessment "delays restructuring and spreads a permanent bad debt program ... through the chain."

The great hope for the market is that it will, with proper oversight, transform itself into a regulated market of corporate and bank debt.

"Corporate bonds aren't like the funny money of veksels," Shestakov said.

There has been an effort among veksel dealers to self-regulate. The non-profit Association of Veksel Market Participants, or AUVER, formed in October 1996 and has enlisted nearly 180 dealers to establish trading rules, a central depositary system and disciplinary measures via an arbitration committee. Those should be presented at an AUVER conference next month.

The Central Bank, meanwhile, has backpedaled somewhat on veksels. Whereas it not so long ago it sought to stop the circulation of veksels as a currency surrogate, now it has decided to enter the fray in an effort to control veksels. The Central Bank has limited to 100 percent of shareholder capital the amount of veksels any bank can issue.

"The situation will be better" with the introduction of AUVER standards, said Olga Tchernikova, the head of the Central Bank's veksel circulation department. "In the first step, [the standards] will only be recommended, but after that we want them to be obligatory."

But regulation might erase the very attractiveness of veksels -- their free-flowing, uncontrolled and high-return nature.

The only way a corporate bond market can emerge, some say, is if the companies begin issuing brand new corporate bonds, in the Western form, with a prospectus and a roadshow.

Veksels "are potentially stoppable as soon as the corporate sector begins structured borrowing and asset growth, and when Russian banks begin to lend to them," said Shestakov.

A veksel is, in theory, a simple IOU -- a promise to pay. But in reality, there are innumerable variations on that simple theme. With a term of generally less than one year, a veksel may be redeemable for cash or commodities; it may trade at a discount or with an interest-bearing coupon; and it may work in closed system of mutual debtors or trade on a freewheeling secondary market.

Here are the main forms of veksels currently on the Russian market:

?Bank veksels make up roughly 40 percent of the total market, according to Renaissance Capital. Normally, veksels of top banks have a fixed term of maturity and can earn 300 to 700 basis points (3 to 7 percent) over Russian treasuries, while veksels of second-tier banks yield 600 to 1,000 basis points over treasuries. Estimated daily turnover in this market is $70 million to $80 million.

There are two kinds of bank veksels: "credit" veksels, which make up the majority of the bank veksel market, and "regular" bank veksels.

With a bank credit veksel, a commercial bank issues a credit to Enterprise X. The enterprise uses the credit to buy a veksel from the very same bank, which in essence guarantees its own credit granted on the enterprise's behalf.

Enterprise X can use the veksel to pay its debtors, and the veksel continues to circulate among debtors, discounted on each transaction. Enterprise Y, for example, would take a veksel with a face value of 100 million rubles for a 10 percent discount, retiring 90 million rubles of debt. It would be passed to the next creditor, Enterprise Z, which might take it in exchange for 80 million rubles in forgiven debt.

The "loan" to the original enterprise, meanwhile, has never left the bank.

Upon maturity, the holder -- an enterprise or a bank along the chain of creditors -- redeems the veksel with the issuing bank. The bank has profited in two ways: It has collected the original 100 million-ruble loan, plus interest, from Enterprise X, and it has been able to invest funds that have never left its accounts.

A variation on the credit veksel was granted through the Finance Ministry, which acted as the guarantor of the note. The federal government used this program as an ingenious way of funding programs and agencies when there was no money for them in the budget. The ministry ceased guaranteeing veksels this year under pressure from the IMF.

Regular bank veksels are also issued by banks, on their own behalf rather than on behalf of a creditor. These function similarly to bank-issued, short-term notes. Bank A, for example, issues a 100-million-ruble veksel and receives 100 million rubles in cash from Buyer X. Buyer X may sell the veksel on a secondary market for a higher price (if it is an interest-bearing veksel) or exchange it for commodities. Upon maturity, the final holder redeems the veksel for face value plus interest.

?Corporate veksels redeemed for cash/ goods. Corporate veksels are riskier -- and, by extension, bear higher yields -- than bank veksels. According to Renaissance, corporate veksels make up over half of the circulating veksel debt.

In a corporate veksel scheme, Enterprise A issues a veksel with a face value of, for example, 100 million rubles. The veksel moves through a circle of debtors to clear mutual obligations and is generally traded at a discount. Such veksels are tightly traded and tend to be illiquid.

Originally, the notes were meant to continue circulating without a final redemption. But a market has matured to include trading in relatively more reliable corporate veksels with maturity dates.

Corporate veksels can also be traded for commodities (diagram, right).

Blue-chip companies such as LUKoil, Gazprom and Almazy Rossii-Sakha first issued veksels to cover debts and would redeem them for oil, gas or diamond shipments. Recently, though, companies such as Sidanco and Severstal have begun redeeming veksels for cash or even issuing them to raise capital.

?Regional or local authority veksels were first issued by the local governments to hospitals, schools and local companies. The veksels circulated in the region, and the final holder may use the veksels to pay taxes. Usually no money changes hands.

This segment equals 5 percent of the market, Renaissance estimated, and like Finance Ministry-backed veksels, these are fading away under pressure from international creditors such as the IMF.

Top five issuers of veksels, banks:

(Outstanding as of July 1, 1997)

billion rubles

Sberbank* 5,623

Uneximbank 3,450

Inkombank 1,170

MFK 863

Avtobank 523

*As of June 1, 1997

Source: Finmarket,

reported by Renaissance Capital

Major corporate veksel issuers:

(as of Jan. 1, 1997)

billion rubles

Gazprom 1,140

Almazy Rossii-Sakha 640

Sidanko 368

Magnitogorsk Metal 342

Severstal Metal 100*


Source: Renaissance Capital

1. Enterprise Y is a creditor of Enterprise X.

2. Enterprise X, a large commodity producer, issues a veksel with a face value of 100 million rubles and uses it to pay off Enterprise Y.

3. Enterprise Y can sell the veksel on the market at a "price" of 40 to 50 percent of face value, or use it to pay off its own suppliers. Enterprise Y needs cash, so a broker buys the veksel for 40 million rubles in cash.

4. The brokerage sells the veksel to a client (Enterprise Z), who wants to "buy" the commodity produced by Enterprise X. The broker sells it to Enterprise Z for 60 million rubles.

5. Enterprise Z goes to Enterprise X and redeems the veksel for 95 million rubles worth of commodity.

6. The broker makes a profit of 20 million rubles, and Enterprise Z makes a profit of 35 million rubles.

Source: Renaissance Capital