A US Treasury ban on US firms buying outstanding Russian government debt looks set to complicate the auction process used to determine payouts on credit default swaps referencing the sovereign, sowing fresh confusion over the fate of these contracts.
Trading volumes in Russian sovereign bonds declined on Tuesday following updated guidance from the Treasury’s Office of Foreign Assets Control that US firms cannot buy Russian bonds or equities in secondary markets. That poses a problem for CDS contracts, which rely on trading in secondary bond markets to determine payouts to protection holders.
The Credit Derivatives Determinations Committee, an industry body consisting of banks and investment managers, ruled last week that Russian CDS had triggered when Moscow failed to make US$1.9m of accrued interest payments on its 4.5% April 2022s to bondholders in May. Experts say derivatives users may have to agree on other methods to settle Russian CDS contracts if US restrictions on buying Russian bonds risk distorting a CDS auction.
“It throws into question how a CDS auction would work,” said one US investor, who said his firm was having multiple calls a day with lawyers to discuss trading of Russian bonds and the settlement of the CDS auction. “There’s lots of confusion and uncertainty – more questions than answers. As it stands, we’re frozen from trading Russian assets.”
The CDS auction is a complex mechanism that uses market forces to determine payouts to protection holders. Among other things, it allows investors and traders to buy and sell Russian bonds to help establish the value of those securities. CDS payouts can then be calculated to ensure protection holders are adequately compensated for losses that they face on bond positions.
Twelve members of the DC voted last week in favour of a failure to pay credit event on Russian CDS, with Citigroup the only firm to vote against. Citi declined to comment. Industry sources noted members of the voting committee are not privy to their firm’s overall position in a particular credit. Citi had previously voted that Russia had incurred a potential failure to pay on the same April 2022s, and its April 2042s, when a separate question had been put before the Determinations Committee in April after Moscow had threatened to make payments on those two US dollar notes in roubles. Any further action was subsequently averted after the sovereign eventually paid in dollars.
The Determinations Committee is scheduled to meet again on Wednesday to discuss Russian CDS. One source said the DC would look to discuss next steps and whether an auction could take place, or whether CDS would have to be settled bilaterally between trading counterparties. There is about US$2.4bn of Russian CDS outstanding, according to a recent JP Morgan report.
"It’s problematic for the auction process,” said Athanassios Diplas, a CDS market veteran who helped to design the auction, adding it is hard to comment further at this stage given the lack of details.
Sanctions prohibiting trading in Russian debt have long been flagged as a potential issue for any CDS auction on the sovereign. Concerns that such a ban could materialise prompted a dislocation between derivatives and bond markets shortly after Russia’s invasion of Ukraine. That gap between the two markets subsequently narrowed as banks were allowed to continue trading Russian bonds – with some reaping significant profits in the process.
The updated sanctions guidelines from the US Treasury only apply to US firms, though traders say this was enough to depress trading volumes across the wider market on Tuesday and Wednesday as participants scrambled to understand the implications. One trader said he thought risk-reduction trades were still okay but he was waiting for clarification. Other traders said there was no activity going through interdealer broker markets.
Many are concerned that a ban on US firms buying Russian bonds could create an imbalance between buyers and sellers in a CDS auction.
“The CDS auction mechanism in its normal functioning needs a secondary market for bonds to allow price discovery and transfer of bonds,” strategists at JP Morgan wrote in a March 2 note. “In situations where secondary market trading of bonds would be prohibited by sanctions, the auction process would not be able to occur in its standard form.”
The strategists said that CDS markets have a “waterfall of settlement fallback mechanisms” if an auction cannot be held. That includes bilateral cash settlement of CDS contracts.
"While possible, this will require a lot of administration to settle each trade bilaterally, and also economically can end up with different recovery rates on different trades. A mechanism that uses cash settlement through the auction mechanism is likely to look more preferable and would allow all CDS to settle at the same recovery rate and efficiently,” the strategists said.