By Dwight Cass
Already hedgers have moved to offshore NDFs; further sanctions could affect more instruments.
The G-7’s June 4 promise to increase sanctions on Russia if it fails to de-escalate the Ukraine crisis has derivatives lawyers and market participants worried. The original rounds of sanctions in March and April caused significant shifts in the foreign exchange derivatives market. Hedgers and lawyers have struggled to ascertain how further sanctions might make settling transactions with Russian counterparties illegal, or at least complicate matters further.
The first indication of trouble was in March, when the market for non-deliverable forwards surged in volume—and began trading at a premium—to the market for deliverable instruments. According to Reuters, a week after the initial sanctions kicked in, “The [NDF] contracts [were] trading anywhere from 3 to 9 kopecks more expensively than the onshore forwards, depending on the size of the contract, traders said. ‘The market is trying to price in the convertibility risk,’ said one trader in Moscow. ‘There is a premium even across one-month contracts.’”
Banks ring-fenced their cash portfolios from their NDFs in case sanctions made it illegal for them to settle in cash. Corporates in particular are said to now want everything settled offshore to insulate their hedging operations from fallout from sanctions.
The concerns are even broader than FX now. Recent legislation proposed in the US would broaden the number of off-limits Russian companies to include top energy firms and banks. According to a client note by law firm Hogan Lovells, these include:
- Sberbank
- VTB Bank
- Vnesheconombank
- Gazprombank
- Gazprom
- Novatek
- Rosneft
- Rosoboronexport
According to Lovells, “The measures to be imposed are asset blocking and a visa ban. Essentially, these entities would be designated as Specially Designated Nationals (SDNs), resulting in the blocking of all transactions relating to property and interests in property of a sanctioned person or entity, if that property has a nexus with the US or if a US person is involved.”
That’s where the problem with derivatives documentation comes in. The ISDA Master specifies when firms can close out and settle up derivatives trades. But US counterparties worry that increasing the scope and severity of sanctions, as some proposed legislation would do, would make it illegal to settle a transaction with a Russian counterparty.
There is also uncertainty over whether derivatives that reference sanctioned companies would be affected. Since there is no precedent for this, and it remains unclear which new sanction legislation might be passed, derivatives lawyers are straining to come up with client strategies contingent on different outcomes. If a trade referencing a sanctioned company is between two non-Russian counterparties, it appears that sanctions shouldn’t cause any problems. However, even that is not a sure thing.
Current sanctions are not seen as more than a rounding error in Russia’s economic troubles. But they are feeding the negative sentiment there. The currency is down about 8 percent so far in 2014, and Standard & Poor’s cut Russia’s foreign currency rating to BBB-, its lowest investment grade rating, at the turn of the month.
Uncertainty around derivatives is not the only contractual issue haunting corporates doing business in Russia. There is a clear list of individuals and institutions that US citizens are barred from doing business with. But stakeholdings in Russia are often hard to determine, as large investors often hold shares through third parties. The US sanctions bar US citizens from doing business or transacting with any company that is more than 50 percent owned by a sanctioned individual, but that may be difficult to ascertain.
Even sophisticated financial institutions are scratching their heads. The Russian government berated JP Morgan last month for refusing to conduct a transfer from its embassy in Kazakhstan to a Russian insurance company. JP Morgan responded that it was attempting to get guidance from US regulators whether such a transfer violated the sanctions because the insurance company was a subsidiary of a sanctioned bank. Also, both Visa and MasterCard halted operations briefly in Russia while they attempted to sort out the provisions of the sanctions.
As tensions mounted and the Crimean crisis began to flare up, regulators in the US and Europe demanded to know what exposures their banks had to Russia and Ukraine, and asked them to run stress tests to ascertain what damage various outcomes would cause to their balance sheets. The UK Prudential Regulation Authority sent out queries at the beginning of March, according to an article in RISK magazine. The magazine reported that, “Foreign banks have a total of $184.5 billion of outstanding exposure to Russia, and $14.9 billion of exposure to Ukraine, according to locational exposure statistics released by the Bank for International Settlements on March 9.”
Quarter-end figures from the BIS showed that most countries’ banks had pared back their exposure to Russia over the previous 12 months. US banks, which had $38 billion of exposure at Q1 2013, shaved that by 12 percent by the end of March. German banks cut their exposure by 18 percent and Swedish banks by 34 percent. The country with the largest exposure—France, with slightly over $50 billion—only cut its exposure by 3 percent.
The remaining significant exposure of the G-7 banks, and the reliance of Europe on Russia’s energy supplies, throws some doubt on the G-7’s tough talk and the possibility of tougher sanctions. Nonetheless, legislators in the US are less concerned with these issues and are pushing two initiatives that would expand sanctions (see below). Which way the pendulum will swing after the recent G-7 meeting in June will be closely watched by corporate hedgers and other derivatives market participants.
US Sanction Proposals
There are two major sanction legislative proposals currently in the pipeline. The Corker Bill (S.2277), sponsored by Tennessee Republican senator Bob Corker, according to Hogan Lovells, “imposes sweeping sanctions if Russia takes heightened action against Ukraine or if it does not withdraw its forces from the eastern border of Ukraine. Such sanctions would target (1) specific major Russian companies (including Gazprom and Rosneft) and banks and (2) all government-owned entities and any companies that operate in certain sectors in Russia. The scope of sanctions depends on whether the sanctions are imposed for failure to withdraw forces or heightened action against Ukraine.”
The second piece of legislation is in the House version of the National Defense Authorization Act, H.R.4435, which would block any funds to the National Nuclear Safety Administration involving “any contact, cooperation, or transfer of technology between the United States and the Russian Federation,” unless the secretaries of Energy, State and Defense say that Russia is withdrawing from Ukraine and respecting its territorial integrity.
The NNSA manages the nonproliferation treaties and inspections of Russian nuclear facilities, meaning this could have a significantly deleterious effect on our ability to cooperate with the Russians on nonproliferation activities. The House passed the bill in late May; the Senate is working on its version now.