Capital Markets Project THE UKRAINE STOCK EXCHANGE ENVIRONMENT: CHALLENGES AND RECOMMENDATIONS Prepared by: Robert L. Smith International Adviser Capital Markets Development January 17, 2006 Robert L. Smith is a senior securities exchange professional with over 30 years diverse experience in regulation, operations, trading and management. He has an in-depth understanding of international best practices for exchange operations and oversight, having held positions with the U.S. Securities and Exchange Commission, NASDAQ, Chicago Board Options Exchange, and with leading investment intermediaries. Mr. Smith has significant direct experience in emerging markets including work in Kazakstan, Thailand, China, Kyrgyzstan, and Georgia. 2 Preface This paper presents an analysis of securities exchanges in Ukraine, focusing in particular on whether the existing institutions have the capacity and independence to support a truly dynamic financial sector for Ukraine. While the focal point of the paper is the Ukrainian exchange environment, the role of the regulator, the Securities and Stock Market State Commission, is examined in the context of its impact on the development of stock exchange operations supporting true price transparency and planning for pension reform investments. In order to more fully speak to these challenges and better understand the role Ukraine’s securities exchanges can and should play in responding to them, the following analysis of the current status of Ukraine’s stock exchange operations was undertaken: • Background--History – review of the historical development of Ukraine’s securities exchanges, the current political and financial issues exchanges face, and the role of the GOU, the private sector, and international donor community. • Technical Capacity Analysis – evaluation of the capabilities of key exchanges active in Ukraine against requirements for a well-regulated and dynamic trading market, measured against international best practices for this market place. The analysis included, but was not limited to, a review of issues such as pricing, information disclosure, listing requirements, and the ability to service the full range of domestic and international customers. This analysis was benchmarked against several comparable markets. • International Best Practices – comparison of Ukraine’s exchange operations against international best practices, including a review of compliance with IOSCO Principles for operation of stock exchanges. The paper is intended to provide a baseline for future technical assistance to improve the operations of securities exchanges to meet market needs and contains short and medium term recommendations. The ultimate goal is to stimulate discussion and policy debate on issues of critical importance to Ukraine’s long-term securities market development, while also helping to establish consensus supporting needed changes in existing institutions, providing a firm foundation for a vibrant and truly dynamic capital markets sector in Ukraine. 3 Acknowledgements A special thanks to the following persons who generously took time to provide substantial input: Mikhail Nepran, Executive Director, Securities and Stock Market State Commission, Igor Olegovich Seletskiy, General Director, Troika Dialog Ukraine, a leading Russian investment bank subsidiary, Ihor Seliverstov, First Deputy Head of the Board of Directors, Ukrainian Interbank Currency Exchange, Irina Zarya, President and CEO, First Ukrainian Securities Trading System (PFTS), Bogdan O. Lupiy, Executive Director, First Ukrainian Securities Trading System, (PFTS), Serhiy M. Oksanych, President, Kinto, an investment company, Anatoly V. Fedorenko, Vice President, Kinto, an investment company, Volodimir Scherban, Head of Supervisory Board, PARD, the Professional Association of Registrars and Depositories, and a licensed SRO, Andrei Kazakov, President, Kyiv International Stock Exchange, Hanna Yatsyuk, Chairman of the Council of Directors, Ukrainian Stock Exchange Denis Butenko, Operations Director Ukrainian Stock Exchange, and Dmitro Tarabakin, Director, Dragon Capital, an investment bank. Valuable support was provided by Victor Sizonenko, translator, interpreter and curator of documents extraordinaire. 4 Abbreviations COM Cabinet of Ministers of Ukraine ETS Electronic Trading System GDP Gross Domestic Product GOU Government of Ukraine (i.e., the COM and the various ministries and agencies, but not the Presidential Administration, the Verkhovna Rada or the courts) IFRS International Accounting Standards of the International Accounting Standards Committee IOSCO International Organization of Securities Commissions JSC Joint Stock Company MFS Interregional Stock Union (operational clearing depository for securities) MOF Ministry of Finance of Ukraine NBU National Bank of Ukraine Rada Verkhovna Rada(Parliament) PFTS Persha Fondova Torhova Systema, (First Ukranian Securities Trading System). SOP State owned property SOS State owned shares SPF State Property Fund of Ukraine SRO Self-Regulatory Organizations SSMSC Securities and Stock Market State Commission UAH Hryvnia (Ukrainian Currency) USAID United States Agency for International Development WFE World Federation of Exchanges 5 Table of Contents Page Executive Summary and Recommendations ………………………………………. Section 1. Importance of an Organized Securities Market………………………. Section 2. Background of the Ukrainian Stock Exchange System……………… Section 3. Ukraine’s Economic Outlook and Recent Developments……………… Section 4. Overview of the Status of Ukraine’s Stock Exchange System………… Section 5. Comparison of PFTS and Ukrainian Stock Exchange 5.1 Review of PFTS Operations…………………………………………………. 5.2 Review of Ukrainian Stock Exchange Operations…………………………. Section 6. Role of the Regulator in Development of Stock Exchange System…… Conclusions 6 Executive Summary In the past two years the Ukrainian equity market has grown from one of the smallest in the region, representing 10% of GDP for 2003 to an estimated 35% of GDP for 2005. This dramatic growth in Ukraine’s market capitalization when compared to Hungary, Poland and Czech Republic is Market Capitalization as Persentage of GDP explained by the positive effect % of the Orange Revolution. 40 Although there are 235 listed 35 companies, the market is highly 30 concentrated, with the market 25 capitalization of the 10 largest 2003 20 2004 companies representing about 2005 70 percent of the market. 15 Despite this growth, the equity 10 market is highly fragmented, 5 lacks price transparency, and is 0 illiquid. Free float by public Ukraine Hungary Czech Poland companies is estimated at Sources:SSMSC, PFTS, European Federation of Stock Exchanges, and World Bank about 4 percent of market capitalization. It is estimated that some 95 to 98 percent of securities transactions occur outside the organized market. The low liquidity in the Equity Turnover ($ Mil) And Number of Listed Companies Ukrainian market, evidenced in Chart 2, as compared to the 45000 40 40000 CES countries is attributed to 35000 corruption, inappropriate 30000 political intervention, and 24 25000 2003 concentration of ownership of 43 55 21 2004 20000 2005 privatized companies in the 46 15000 hands of Ukraine’s six major 51 38 18 10000 financial groups. This results in 5000 262 167 191 few actively traded companies 0 Ukraine Hungary Czech Poland due to the low number of its Sources: SSMSC, PFTS, European Federation of Stock Exchanges, and World Bank shares available for trading. Recent political intervention is evidenced by the Presidential Decree dated November 24, 2005. This Decree directed that pension funds invest only in shares listed on a “securities exchange.” Likewise the Decree mandated that State owned shares be sold and traded over stock exchanges, and that state owned enterprises must be listed on stock exchanges. Yet the existing stock exchanges lack the institutional capacity to provide a fair and transparent market for this State dictate. These directives, if implemented, will favor the financial security of weak ”pocket” exchanges at the expense of a vibrant capital market and pension reform. Support of dormant stock exchanges can only lead to price manipulation and further corruption. The current fragmentation of the market flows from decisions made to facilitate mass privatization in the mid 1990s, in which the regulator, acting more as an administrator of the market than a regulator, licensed regional stock exchanges to handle privatizations of local enterprises. Today, Ukraine has 10 trade organizations licensed by the SSMSC, 8 of 7 which are licensed as a stock exchange, and 2 licensed as trade information systems 1 (electronic trading systems), which is well in excess of the markets needs. The two most active trade organizations are PFTS, an electronic trading system, which accounts for more than 86% of all trading volume, and the Ukrainian Stock Exchange, established in 1991, which accounts for approximately 12.6% of trade volume. The remaining 8 trade organizations, 7 exchanges and one electronic trading system, are practically dormant, but with random trading, further exacerbating the fragmented market, and adversely affecting price and liquidity. These dormant trade organizations remain open solely in the hope of participating in privatization and sale of state owned shares (SOS), capturing the facilitation Source: PFTS commission of 1 percent of the sale proceeds of SOS. It has also been widely noted that when an occasional trade is transacted though these organizations it