Russia credit default swap protection holders are set to receive what many may consider a smaller-than-expected payout following the conclusion of a closely watched auction process on Monday to establish the value of the contracts.
After months of painstaking preparations, which have been complicated by Western sanctions against Moscow, the auction determined a settlement price of 56 cents for Russia CDS. That means CDS holders will recoup 44 cents for every dollar of default protection they bought on Russian hard currency debt.
While substantial, that is still well below levels implied by Russian bond prices in the immediate aftermath of Moscow’s invasion of Ukraine, some of which traded below 20% of face value (suggesting a potential CDS payout of more than 80 cents for every dollar). The final settlement price of 56 is also above the initial market midpoint of 48 cents established in the first round of the auction, where dealers provide indicative bids and offers on Russian bonds.
Overall, though, market experts welcomed the successful resolution of the auction following months of uncertainty in what has proven to be a fraught and complex process to settle Russia CDS contracts.
“I think the CDS market will be relieved that the auction worked consistently with how it’s designed to work," said Athanassios Diplas, a former Deutsche Bank executive, who helped design the CDS auction process.
“The outcome really depends on which way the risk is going. This time, the physical settlement request was sizeable and the imbalance between buyers and sellers of bonds was enough to push the final CDS settlement price several points away from the initial midpoint and lower the payout somewhat," he added.
The stakes were high for the Russia CDS auction, after the Credit Derivatives Determinations Committee, an industry body of banks and investors, ruled Russia CDS had triggered earlier this year when Moscow failed to make some small interest payments on its external debt. CDS users knew an unsatisfactory outcome could undermine the value of these contracts as an effective hedge, something that has been repeatedly called into question since Greece’s debt default over a decade ago.
There has also been a more pressing concern for some of the investment banks that have used CDS to hedge Russia-related exposures this year: the fact that there are still material amounts of money resting on the result. Deutsche Bank’s chief financial officer, James von Moltke, previously said that the German lender was waiting to see the CDS settlement process to gauge how much it stood to lose from its Russia exposure.
Overall, strategists at JP Morgan said there are about US$2.4trn of Russia CDS to be settled across both single-name contracts and credit indices.
There were a large number of requests to settle the contracts physically in the first stage of Monday’s CDS auction, resulting in a net open interest of just over US$500m to buy Russian bonds. That shows the demand was high among sellers of default protection on Russia to take physical delivery of the bonds, suggesting they might think there is further upside in Russian debt prices.
"It’s not surprising to see a bunch of CDS holders asking for physical settlement in the auction, because they may think that some day they’ll get a much higher recovery rate on the bonds," said John Williams, a partner at law firm Milbank, who helped create much of the modern CDS market architecture.
"In a normal distressed event, there can be varying views on the underlying recovery value of the debt, but it’s more of a spectrum of outcomes. This is essentially bimodal: Russia has plenty of money and has wanted to pay bondholders, but Western sanctions have prevented them from doing so. In that sense, it’s a more difficult situation to design an auction for."
A US Treasury ban on US firms buying Russian in secondary markets had threatened to derail the CDS auction process earlier this year. That is because the auction mechanism requires bank trading desks to be able to buy and sell Russian debt to establish a fair payout for CDS holders.
In the end, the derivatives industry managed to secure a temporary carve-out from the sanctions that permitted trading of Russian bonds two business days before and eight business days after the auction.
"Those protection sellers that asked to take physical delivery of the bonds will now have to ride the bond risk going forward," Diplas said.