With the beginning of the war in Ukraine credit default swaps (CDS), which could be translated as “derivative credit events”, are traded en masse. We have not been so enthusiastic about these financial products since the Greek debt crisis, and it is not reassuring. This time, Russia’s debt is at the center of all speculation, mainly because of the country’s financial sanctions, including the freezing of more than 600 billion euros in assets abroad, which Moscow.
At first glance, this was not a bad thing, as these financial products are presented as insurance against the risk of non-repayment of debt, except that, unlike usual, it is the insured bank, not the borrower. At the same time, in the case we are interested in, financial institutions provide insurance in case Moscow fails to repay its sovereign debt. These CDS are created over time, as are borrowings.
For example, Moscow is in debt for 5 years to Bank A for 1 billion euros. The latter decides to conclude a 5-year CDS with another financial institution B. Each year Moscow reimburses its maturities with interest A and A pays 1 million B. If Russia repays its loan, Bank A repays its interest rate and B. wins 5 million euro without doing anything. But if there is a default, it is B who reimburses the billion bank A.
The value of CDS far exceeds the value of debt
The first problem with CDS is that because banks are insured against default, they can afford to be very slow when it comes to checking the borrower’s creditworthiness. Another serious concern is that the financial institution with which the lending bank takes its CDS has absolutely no obligation to have a reserve sufficient to repay the initial loan in case something goes wrong.
From January, the cost of the village CDS Russia’s debt has been multiplied by 100. The treasury is not empty: Russia has bought gold reserves for 630 billion euros, and the sovereign wealth fund is endowed with 200 billion euros.
For traditional products, the bank must have equity (8%) of the money it places in the financial markets, but this does not apply to CDS. What’s worse, anyone can get CDS on someone else’s debt, even if they haven’t borrowed money, losing their initial sense of insurance. The product becomes purely speculative between two entities that have nothing to do with the loan: one bets that the debtor will not default, the other – if, and the amount of payments is discussed according to the assessed risk. Thus, outstanding CDS on the loan can significantly exceed the value of the debt itself.
Finally, to make disaster inevitable, CDS, like debt, can be cut and resold as derivatives. They then find themselves agglomerated into complex and opaque financial products, CDOs (mortgage bonds) with many other debt tranches. As the contract is concluded without a prescription, the state authorities practically do not control it.
That is why Russia is in financial need today. In early April, a tranche of Russia’s public debt secured by CDS was sold on the Intercontinental Exchange (the main market for CDS) for $ 7.3 million, plus $ 100,000 a year. This means that speculators are so confident that Moscow will default to 7.3 million in order to receive compensation as soon as 10 when the state goes bankrupt. Some banks that have lent money to Russia are interested in the country not reimbursing them if they are insured in order to recoup their investments as soon as possible. Absurd, but the value of the CDS was the best measure of the probability of default: at 5.8 million, the probability of bankruptcy of Russia was 71%, it rose to 90% at 7.3 million.
Last March saw the first escape of the CDS market, when Moscow had to pay more than 100 million euros in interest on debt. But despite the sanctions, Moscow was able to pay off. Russia is expected to return more than 600 million euros in April. On the 4th, the deadline for payment, Russia requested a deferral of payment and received 30 days. This is because the stock market “value” of 10 million Russian debt increased from 2 to 7.3 million.
If there is a default, the chain consequences could be dramatic, and not just for the Russians.