‘Dead’ derivatives market leaves big Russia dealers unhedged

Russia’s over-the-counter derivatives market has been declared “dead”, as foreign banks try to escape trades with local dealers in the wake of swingeing international sanctions. The move is likely to leave Russian banks such as VTB and Sberbank stuck with unhedged exposure to local clients.

The US announcement of full blocking sanctions on VTB requires dealers to unwind their exposures to the bank by May 25. Sanctions on Sberbank, Russia’s largest lender, are less stringent, with foreign entities prevented from processing US dollar transactions with the bank from the end of this month. But, in practice, this also means foreign dealers must exit their derivatives positions since most collateral agreements between Sberbank and its foreign counterparties require margin to be paid daily in the US currency.

Foreign dealers are now hurrying to terminate these trades, according to a derivatives source at one of the Russian banks who has been involved in the efforts, and confirmed by an executive at a US bank. The dealers are relying on an escape clause in the contracts that allows the transaction to be cancelled if legal barriers arise. New trades are also being refused.

Sberbank had around $40 billion in gross fair value of derivative receivables at the end of 2021, mostly in foreign exchange and rates. VTB’s figure is likely to be less than $2 billion.

“All banks have closed their lines because all derivatives are done in dollars,” says the Russian bank source. “The derivatives business is dead in Russia, completely.”

The source adds that derivatives trading with international banks continued as normal up until the beginning of the war on February 24. The imposition of sanctions by western governments later that day prompted foreign banks to urgently review their exposure to Russian entities.

But as foreign dealers terminate existing trades and block new ones, Russian banks are being left with unhedged positions facing local corporates. These clients come to the Russian dealers primarily to manage their own interest rate, currency and commodity exposures, leaving three banks in particular – Gazprombank, Sberbank and VTB – with large books of ruble and foreign currency interest rate swaps, US dollar/ruble cross-currency swaps and various commodity derivatives.

It’s still possible for Russian banks to trade among themselves, but the source says this would not help in many cases as the banks would be trying to hedge very similar sets of exposures. Most of the corporate flow is one-way – “there are not both sides of the market”, says the source. Russian banks rely on foreign dealers to hedge this exposure, but the forced exit of these dealers will leave Russian banks holding the risk.

Time to unwind

Sberbank’s fourth-quarter 2021 financial statement shows the gross fair value of its over-the-counter FX swap receivables, which likely includes cross-currency swaps, was 3.6 trillion rubles ($26 billion). For ruble interest rate swaps it was 60 billion rubles; foreign currency interest rate swaps was 1.22 trillion rubles and commodity swaps was 216 billion rubles. The total figure is 5.1 trillion rubles.

According to its 2020 annual report, VTB had derivatives assets of 224 billion rubles at the end of 2019. More detailed information was not available as the bank’s website is currently not accessible.

The foreign currency interest rate swaps are generally centrally cleared, where margin is also required in US dollar cash. The remaining derivatives are non-cleared, meaning they are subject instead to the market’s standard bilateral agreement on margining – the credit support annex. The Russian bank source says these contracts generally specify that daily variation margin must be paid in US dollar cash.

The US Treasury announced on February 24 sanctions on VTB that immediately prohibited any new transactions with the entity and required banks to unwind existing derivatives positions. Banks can enter new trades with VTB that serve to unwind existing derivatives until May 25. UK sanctions announced on February 24 gave entities just 30 days to unwind positions with VTB. Banks are reportedly seeking an extension to this deadline.

The European Union will also block seven Russian banks – including VTB but excluding Sberbank – from the Swift messaging system, a move that is expected to stall or halt international payments from those entities.

As a result, foreign banks have been looking to quickly unwind cleared and non-cleared trades with all sanctioned entities, as processing their US dollar margin flows will soon become impossible.

London-based lawyers confirm unwinds have already taken place ahead of the sanctions coming into force, with many relying on illegality clauses in the International Swaps and Derivatives Association documents that allow for terminations where the contracts face legal restrictions.

The source at the Russian bank says there are no moves to try to get Russian corporates to unwind their derivatives. Currently, senior management at the source’s firm are more focused on other issues such as loan and bond exposures, making management of the derivatives book a lower priority.

Unwinds have been proceeding in an orderly fashion so far, the source says, and close-out valuations have been largely uncontested. Arguments about the value of various derivatives valuation adjustments have been put aside in favour of a speedy resolution.

“From what I’ve seen, the approach is to do what you’re asked to do and not try to negotiate, because there’s no time or space to negotiate,” the source says.

Editing by Alex Krohn