Russian CDS finally pays out

Russian CDS contracts have finally paid out on 12 September following months of complications given Western sanctions against Moscow (SCI 8 March). Nevertheless, an imbalance between Russian bond supply and demand persists and that remains to be cleared.

The auction determined a settlement price of 56 cents for Russia CDS. This means CDS holders will recoup 44 cents for every dollar of default protection they bought on Russian hard currency debt.

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, market participants have welcomed the successful resolution of the auction following months of uncertainty. On June one, the ISDA Determinations Committee (DC) resolved that a failure to pay credit event had occurred with respect to the Russian Federation and an updated guidance from the US Treasury on June six called into question the ability to hold a CDS auction.

Robert Daniell, senior counsel at Macfarlanes notes: ‘’ On June six, the US Treasury’s Office of Foreign Assets Control (OFAC) issued an unexpected guidance on existing US sanctions that had been in place since shortly after the invasion, stating that the sanctions operated to restrict purchases of any Russian bonds, and not just those issued after the date the sanctions were first applied.’’

He continues: ‘’As a result, major dealers stepped back from offering prices to buy Russian bonds, which would have made it impracticable to hold an auction of Russian bonds to determine the settlement price of credit derivatives. However, the issue was resolved on 22 July, when OFAC granted a specific licence to allow dealers to participate in a credit derivative auction.’’

Indeed, if you can’t run an auction then you can’t readily settle a CDS contract. The only relevant precedent for sanctions affecting an auction were the US sanctions on Venezuela, where ISDA organised a multilateral agreement among market participants to amend CDS contracts to reference only legacy bonds unaffected by sanctions. However, the fact that Russian sanctions affected bonds issued prior to the date that the sanctions came into force, rendered current concerns far more significant.

Athanassios Diplas, principal at Diplas Advisors and one of the architects of the CDS auction process comments: ‘’Sanctions raised additional questions as to what counted as a deliverable obligation and hindered the ability of dealers to trade and find a settlement price that truly reflected the risk. Most participants are incentivized to submit physical settlement requests and this one was no exception. Physical settlement affects the auction in a way that better reflects the actual pricing of the bonds.’’

He continues: ‘’Nevertheless, there’s an imbalance between supply and demand following the first stage of the auction and the required bonds are sourced via a Dutch auction process in the second stage of the auction. This means that participants submit prices and their desired notional, and the final price for the auction is the one that clears the full target notional. It’s a process that is similar to what is used in the US Treasury market.’’

The most relevant questions ahead of a CDS auction are the mechanics of the auction and those factors that will determine the final recovery rate. These are the cheapest-to-deliver bonds, which will set the initial mid-market price point in the first round of the auction, what the likely net buy/sell open position will be at the end of the first round, and what technicals there will be in the second round where anyone-even those without CDS-can buy in limit bids.

According to JPMorgan estimates, there is currently US$2.37bn of Russian CDS net notional that must be settled, including US$1.54bn from single name and the remainder from CDX.EM index positions.

Stelios Papadopoulos