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Watchdog blocks Russia from settling its foreign debt in rubles, teeing up a $6 billion battle

April 21, 2022, 8:52 AM UTC

Russia is moving closer to its first default on foreign debt in over a century, after a watchdog ruled that the country’s attempt to settle a $649 million dollar-denominated interest payment in rubles isn’t going to fly.

The Kremlin attempted to use rubles to meet an interest payment on some of its $40 billion of sovereign debt early this month, after U.S. sanctions prevented the country from settling its interest payments in dollars. But the Credit Derivatives Determination Committee—an influential body that includes major banks like Goldman Sachs and Barclays—declared on Wednesday that rubles aren’t good enough.

Moscow’s bid to settle debt in its own currency instead of the dollars it owes constitutes a potential “failure to pay” event, the CDDC said.

Technically, Russia hasn’t defaulted quite yet. While the payments were due on April 4, the country now has a 30-day grace period to make a payment in dollars. But Western sanctions on Russia mean that the country is unlikely to make the dollar payment on time, setting the stage for its first default on foreign-owned debt since 1918.

But the pain for Russia’s ill-fated creditors doesn’t end there, as a Russian default would kick-start a convoluted process to settle the $6 billion in credit default swaps tied to Russian sovereign debt.

A credit default swap (CDS) is a financial instrument similar to insurance, used by bondholders to offset the risk of the bond issuer defaulting on payments. A bondholder pays a CDS issuer—usually a bank or insurance company—a regular premium in exchange for a promise that the CDS issuer will buy the debt off of the bondholder in the case of a default. That way, the bondholder isn’t left holding a worthless scrap of paper.

At the beginning of February, premium payments on a Russian CDS cost just 5% of the bond’s face value, which is the amount the bond pays upon maturity. By Wednesday, the premium on a five-year contract for a Russian CDS had risen to 73% of the bond’s face value, as a default appears increasingly likely.

But even though a Russian default seems imminent, U.S. sanctions against Russia mean bondholders might struggle to cash in on their CDS “insurance” plans.

J.P. Morgan analysts noted in March that sanctions have frozen the secondary market in Russian bonds, which would make it difficult for CDS issuers to determine how much Russian bonds are worth after a default. Without knowing a bond’s value, issuers won’t be able to determine how much compensation bondholders are due.

But even if CDS issuers do settle on a fair rate, sanctions might prevent bondholders from transferring their debt to the issuers as part of the settlement, because banks are technically prohibited from trading some Russian debt. That means the credit default swap process can’t be completed.

It could be that sanctions against Russia will cause an unlucky holder of Russian bonds to lose out twice—once on the value of the bond when Russia defaults, and once again on the hedge they bought against the first.

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