Russia’s Imminent Default: What You Need to Know About Default Insurance

Due to sanctions imposed by the West in response to the invasion of Ukraine, Russia has only limited options to repay its foreign currency loans. The CDDC Investment Committee responsible for the Europe, Middle East and Africa (EMEA) region has already classified Russia as delinquent because the country failed to pay interest on a late redemption of a bond within the usual grace period.

It was only a small sum of 1.9 million dollars. Non-payment insurance buyers can now claim their damages from providers of so-called credit default swaps (CDS).

WHAT ARE CREDIT DEFAULT SWAPS (CDS)?

It is essentially an insurance policy that bond buyers use to protect themselves against certain risks. Bond investors often buy CDS on the bonds they hold to protect against default. The CDS can be tailored to individual customer needs. Some investors also speculate directly with CDS. This means that they do not own any securities that they want to protect against default, but instead rely on the price gains of the CDS themselves.

HOW DO I BUY A CD?

In principle, any financial actor can issue and sell a CDS, not just insurance companies. Large investment banks often offer these papers to their clients. The costs of this depend on the probability of failure.

WHEN DOES THIS INSURANCE COVER?

A market participant, usually the buyer of a CDS, asks the Credit Derivatives Determinations Committee (CDDC) to verify whether the so-called credit event has occurred. Experts understand this to mean a debtor’s default or debt restructuring. There are five CDDCs around the world, each responsible for a specific region. This body is made up of up to 15 members with voting rights, who are mostly delegated by the big banks and asset managers.

WHEN DOES A “CREDIT EVENT” OCCUR?

There are five basic scenarios that count as a credit event: bankruptcy, default, debt restructuring, payment moratorium, and obligation acceleration. In the latter case, it is not the actual bond that is delinquent, but another liability, causing the insured bond to mature early.

WHATS NEXT?

If the CDDC detects a credit event, the CDS buyer transfers the insured bonds to the CDS seller and receives the face value of the bonds from the CDS seller. If the CDS buyer does not have the securities insured because he only speculated on the CDS itself, he must find them. If this proves difficult, the parties can also come to a purely financial agreement of the deal, without the bonds changing hands.

WHY IS IT SO COMPLICATED WITH RUSSIAN BONDS?

The fine print on some Russian dollar bonds states that the state can manage the ruble securities if dollar payments are not possible. However, due to Western sanctions against Russia, it is currently almost impossible to exchange rubles for dollars or euros. Therefore, it is not clear whether an interest payment in rubles should already be considered a default. The responsible CDDC has already been commissioned to examine exactly that.

In addition, Russian bond trading is suspended, preventing creditors from overwriting their bonds to CDS sellers. Therefore, they could argue that they do not have to pay for their insurance policies.

WHAT TERMS DO I NEED TO KNOW?

Credit Event: Occurs due to default or debt restructuring.

Default (default): paraphrase of a bankruptcy. Loans can no longer be repaid.

Haircut: This means debt relief. Creditors waive part of their credits.

Restructuring: Here we are talking about debt restructuring. May include debt relief. It is also possible to extend the term and/or reduce the interest payment (coupon) of the bonds.

Upfront Payment: For borrowers who are considered to be on the verge of bankruptcy, CDS sellers often require an upfront payment, which is added to the other premium.

HOW TO READ THE PRICES OF THE CDS?

CDS prices are usually quoted in basis points. 100 basis points is one percent. If the price of a CDS is 100 basic points, one percent of the insured sum must be paid annually as a premium. With a bonus package with a volume of ten million euros, it would be 100,000 euros. Similarly, advance payments are also expressed in basis points.

(Reuters)

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