When a few weeks later Russia invaded Ukraine, the financial sanctions that were consequently imposed were often accompanied by time-limited licences to allow western firms to extricate themselves from their exposures. This allowed many western firms to avoid the worst outcomes that we observed in our article, although there were some that suffered from those sanctions.

In contrast to the earlier approach of granting licences, the attitudes of the sanctions authorities, particularly in the United States, could be said to be hardening. The time-limited licences have in many cases expired without renewal and in some cases were not available, putting some firms in a difficult position. Moreover, two recent actions of the US Treasury have now created further difficulties.

Expiration of the special licence to make payments in dollars

The US Treasury has not extended a special licence granted to some Russian entities to use the dollar settlement system to make payments, allowing the existing right to expire on 25 May 2022. Russia reportedly made an early payment of two Eurobond interest coupon payments that were due on 27 May to avoid an immediate default, but there are reports that this was not received by at least some holders. Russia has said that it is willing to pay in roubles but, as the bond terms do not permit this, Russia is expected to be in default after the expiry of a 30-day grace period under the bond terms. Separately, on 24 May Sberbank announced that it had made payment of a dollar-denominated Eurobond in roubles, which we understand similarly amounts to a default under those bonds.

Russia is reportedly earning around $1bn a day in fossil fuel exports, so is readily able to service its Eurobond debt. We understand that around half of Russia’s $40bn Eurobond debt is held by non-Russians. The odd result of the US decision is that the non-Russian holders of Eurobonds will suffer the financial harm of ceasing to receive dollars, with little significant harm suffered by either Russia or Russian holders of Russian Eurobonds.

The majority of credit derivatives on Russian entities are on either Russian sovereign debt or that of Sberbank. If “credit event” occurs, which would then result in an auction on debt of the defaulted entity being run.  Under the auction, potential buyers and sellers of that debt would transact, and the market-clearing price set in the auction would then be applied to credit derivatives referencing the defaulted entity.  However, preparations for an auction on Russian debt have now been impacted by guidance issued by the US Treasury this week, as discussed in the next section.

Guidance that secondary market purchases of Russian securities are not permitted

Through an executive order in March 2022, the United States prohibited “new investment in any sector of the Russian Federation economy” (see article 1(a)(iii) of Executive Order 14068). 

This order was widely interpreted as prohibiting purchases of securities issued on or after the date that the sanctions were imposed. However, on 6 June the US Treasury gave guidance that all secondary market purchases of Russian securities are prohibited. A secondary market purchase from a non-Russian owner of a security issued prior to March 2022 would not directly result in investment in Russia, so it can be questioned whether this guidance correctly interprets the scope of the executive order. Questionable or not, the Financial Times has earlier this week reported market participants saying that all the major bank dealers had ceased transacting in Russian bonds.

If the US Treasury interpretation stands then those entities that would normally participate in a credit derivative auction and which are subject to US sanctions will be unable to buy in an auction of Russian bonds. A combination of the US Treasury interpretation restricting those subject to US sanctions and an unwillingness by those not directly subject to US sanctions to buy Russian assets might lead to it being impracticable to run an auction that is able to determine a representative price. 

On 8 June the EMEA Regional Determinations Committee (consisting of 15 significant credit derivatives participants), having recently determined that Russia had suffered a credit event, resolved to defer making any determinations in relation to holding an auction or the date of that auction. If the Regional Determinations Committee determines that the auction cannot reasonably be run then the first fallback under a standard credit derivative on Russia would be for the protection buyer under each credit derivative to physically deliver to the protection seller a bond of the defaulted reference entity. If it is illegal to deliver such a bond, as would be the case if the protection seller was subject to US sanctions, then the second fallback is to cash settlement. This would require the parties to poll dealers for the price of those bonds. Although polling dealers for prices of bonds that those dealers are unable to purchase may be contentious and gives rise to questions of whether it breaches competition and anti-trust laws, it is conceptually possible that a price could be widely agreed across the market such that all dealers would quote the same single price, leading to a single cash settlement price, and for some months now such an approach of a uniform cash settlement price has been considered by market participants and ISDA.

Perhaps more troubling is what occurs if the protection seller is not subject to sanctions, but the protection buyer is. In that case it would not be illegal to deliver the bonds. If a credit event is triggered and physical settlement applies, if there was no delivery and no mandatory fallback to cash settlement then the protection would be unenforceable. A protection buyer subject to US sanctions that did not have sufficient bonds available to deliver (as might be the case for a dealer that has a limited physical inventory of the bonds compared to the size of its matched book of credit derivatives) would be prohibited from now buying more. The contractual test of it being illegal to deliver to allow a fallback to cash settlement would not be met on the sole basis that a protection buyer could not now buy bonds in order to deliver.

Together this means that, if the auction fails, a party subject to US sanctions that has insufficient inventory to meet the demands for physical settlement on credit derivatives under which it is the protection buyer is likely to see a proportion of its protection unenforceable, but would still need to pay out on all of the protection that it has sold. 

For the sake of a properly functioning market, this is a result to be avoided. We will have to see whether in the coming days the US Treasury provides a clarification to its clarification, or whether the Regional Determinations Committee is able to develop a solution to allow an auction to proceed that is able to determine a representative price or otherwise determine a mechanism to impose a uniform price on the market.

This article was updated on 27 June.