CDS market ponders Russian sanctions

Western sanctions on Russia  are putting the CDS market in relatively uncharted territory given the challenges it potentially raises for the running of auctions. Indeed, the latter hampers liquidity and the settlement of CDS contracts. The situation is further complicated by the Kremlin’s decision to allow repayment of bonds in roubles since this could trigger more cumbersome restructuring events. 

According to Julia Lu, partner at Ashurst, ‘’these sanctions are unprecedented for the CDS market because they have severely hampered liquidity.  If there is no liquidity, the auction price could be skewed or unavailable, which could affect protection payments.  Also, if no debt is transferable, then there may not be any deliverable obligation, and there are no protection payments.’’

JP Morgan notes that primary market participation in non-ruble bonds has been prohibited since 2019, while secondary market participation is allowed for existing bonds but banned on both ruble and non-ruble bonds issued after March 2022. Only the hard currency Russian government bonds are relevant for CDS; local currency bonds are not. As it stands, the sanctions themselves do not prohibit trading in the $39bn of existing Russian government hard currency bonds in the secondary market.

If the terms of the obligation are that the payments need to be made to a trustee in let’s say Luxembourg, then a question arises as to whether for instance a Russian company will be able to make payments to the trustee. If not, then that would trigger a failure to pay event. However, if the payment is made in Russia, then the issue of payment location might not arise.

Another challenge is the currency in which these payments are made following the Russian government’s decision to repay foreign bond investors in roubles. JP Morgan states that Russian local law/currency bonds (OFZs) are not in scope for consideration for CDS. Hence, non-payment on these will not affect Russian CDS. There are, however, some Russian government Euro and USD bonds with an alternative currency settlement mechanism to pay bonds in Roubles. Indeed, six of the bonds have this fallback mechanism states the US bank. 

Lu explains: ‘’failure to pay doesn’t specifically refer to currency but does refer to the ‘terms’ of the obligation. Yet before we get there, there’s the question of restructuring. If you look at the restructuring definition which does refer to changes in currency, a change of currency that is binding to all holders could potentially trigger a restructuring. Restructuring definitions are more complex with an extra requirement of deterioration in creditworthiness which is considered more subjective."

However, for JPMorgan, the most relevant CDS trigger is likely to be a failure to pay. JPMorgan notes: ''In situations where the payment chain is disrupted this raises the question of what is considered a ‘payment'. CDS will follow the terms of the bonds in defining what a payment is. For Russia sovereign bonds, this is a payment into the account of the bondholder or equivalent. In order for a coupon payment to be successfully paid, Russia needs to have channeled funds to the paying agent, who then distributes the payments to bondholders. Given the restrictions on the central bank and Ministry of Finance, this payment chain looks like it is restricted.''

Nevertheless, the most salient question remains the one pertaining to auctions. Even if all event definitions are satisfied but you can’t run an auction then you can’t settle a CDS contract.

The answer to this question rests with the determination committees. ‘’If there’s no liquidity you can settle trades bilaterally, but in a case of illegality there’s really nothing much you can do’’ remarks Lu.

The situation is further exacerbated by the lack of any precedent and a solution would require sophisticated moves from the committees.

The only relevant precedent are the US sanctions on Venezuela where ISDA helped amend the CDS contracts to reference only legacy bonds unaffected by sanctions.

The CDS market is watching closely what will happen on March 16 when Russia is required to make payments on sovereign debt.

Moody's has already downgraded the Russian Government’s long-term issuer and senior unsecured debt ratings to B3 from Baa3. The ratings remain on review for further downgrade.

Stelios Papadopoulos