Ukraine-related sanctions issued a day before the Malaysia Airlines flight was shot down appear to have largely spared the derivatives market, but broader sanctions could complicate matters for derivative end users.
The US Department of the Treasury’s Office of Foreign Assets Control (OFAC) made the unusual move July 16 of issuing a general license detailing how to implement sanctions alongside the sanctions themselves. Josh Cohn, head of Mayer Brown’s US derivatives and structured products practice, said OFAC typically issues such a license after a number of market participants have applied for it.
In this case, however, market participants buttressed by trade associations including the International Swaps and Derivatives Association (ISDA) expressed concerns about the sanctions’ impact on derivatives referencing the sanctioned entities and the systemic risk that introduced.
“With respect to these recent sanctions, the purpose of license was to largely take the derivatives market out of the sanctions, except to the extent the sanctions facilitate the holding, purchase or sale of the sanctioned debt or equity,” Mr. Cohn said. “It’s clear OFAC was trying to diminish the impact of sanctions on the derivatives market.”
The global financial crisis clearly showed how troubles in the structured products markets can lead to much broader financial instability. Nevertheless, the Malaysian Airlines incident as well as the two Ukrainian fighter jets shot down July 23 point to an escalating crisis that could prompt additional sanctions.
The sanctions announced last week are described as “sectoral,” which typically cover entire industry sectors or countries, but in practice they’re aimed at specific individuals and entities, including several Russian banks, energy companies and manufacturers. An escalating crisis would also likely pressure the administration to broaden sanction targets and perhaps impose genuine sectoral sanctions.
If so, a broader array of US derivative users could be impacted. The impact so far appears limited, given only companies licensed in the US are affected. It’s unlikely those entities, defined as “US persons,” would enter into derivative contracts directly with one of the specifically sanctioned Russian banks or other companies, although potentially a US corporate, to hedge credit exposure, could enter into an index swap referencing one of them.
Paragraph A of the general license “makes it pretty clear that sort of trade would be OK,” noted one source tracking the issue.
In addition, current sanctions impact the debt and equity of the sanctioned entities, and only if the underlying asset is actually delivered. Derivatives settled in cash and commodity derivatives, such as energy-related swaps, are not impacted.
The source said questions do remain, such as what constitutes debt or the nature of a derivative in the context of the license, and just how broad the license is. Those questions and their answers will emerge over time, the source said, adding that any concerns corporates may have about derivatives currently on their books or under consideration should be run past counsel and OFAC, if necessary.
The concerns presented by ISDA and others stemmed from the uncertainties the sanctions posed that could impact market participants’ ability to price and settle transactions, and whether some could be terminated.
“All those things are uncertainties that effectively cloud the value of the derivative and make it a financial and accounting problem,” Mr. Cohn said, noting that hopefully OFAC would take those same concerns into account should sanctions be broadened.