© . FILE PHOTO: A Russian ruble banknote is seen in front of a falling and rising stock chart in this illustration, taken March 1, 2022. REUTERS/Dado Ruvic/Illustration/File Photo LONDON () -The risk of a Russian default is declining focus for the insurance policies known as Credit Default Swaps (CDS) that investors take out for these types of situations. Here’s how CDS works and why the situation in Russia means the situation may be more complicated than usual. WHAT ARE STANDARD CREDIT SWAPS? CDS are similar to an insurance contract and offer the buyer protection against specific risks. Investors often buy them as protection against default on a specific bond they’ve bought, but they’re flexible and can be customized to cover different scenarios, timeframes, or multiple countries, companies, or banks at once. HOW TO BUY A CDS? CDS are sold by many of the world’s major investment banks because investors want to hedge their risk when buying a bond. The costs depend on the risk that you will not be reimbursed. WHEN WILL THIS INSURANCE BE PAID? The process begins with a market participant, usually an investor who has purchased a CDS, and asks a group known as the Credit Derivatives Determinations Committee https://www.cdsdeterminationscommittees.org/about-dc-committees(DC), to see if a default or ‘credit event’ has occurred. There are five DCs https://www.cdsdeterminationscommittees.org/about-dc-committees/current-dc-membersdc-members-april-2021-to-april-2022/#EMEA for different parts of the world. They can have a maximum of 15 voting members https://www.cdsdeterminationscommittees.org/about-dc-committees/current-dc-membersdc-members-april-2021-to-april-2022/#EMEA which is mainly banks and investment funds using CDS use or sell, such as Goldman Sachs (NYSE:), JPMorgan (NYSE:), Bank of America (NYSE:), PIMCO, and Citadel. Their role of the DC is to apply the definitions of what constitutes a standard error to the specific circumstances, and to make “factual, fact-based determinations”. There are five commonly identified non-payment scenarios. These are bankruptcies, defaults, a debt restructuring, an accelerated default of obligations – where a payment could be caused by a default on another bond, and finally a rejection or deferral of payment – where the borrower actually refuses to pay. WHAT HAPPENS THEN? If it is agreed that a non-payment event has occurred, the CDS contract must pay out, the investor has the right to hand over their bond to the CDS seller and receive 100% of the face value of the bond in return. In the event that the investor didn’t actually have the bonds, they should buy it from someone who does. That process is facilitated by what is known as the CDS bond auction when participants look to the bond markets and try to figure out what the defaulted assets are worth. Cash settlement instead of physical settlement is normally an alternative if it proves difficult. WHY IS THIS SITUATION COMPLICATE? There is a potential problem in that important ‘settlement’ part of the process. That’s because six of Russia’s $15 or Euro-denominated international market bonds have legal fine print that allows the government to make its bond payments in rubles if “the Russian Federation is unable to pay principal or interest (in whole or in part). in part) in respect of the US dollar denominated bonds”. If Moscow uses that ‘fallback’ option, it will cause headaches, as Western sanctions currently make it difficult to convert the rubles back into dollars or euros. Further sanctions that would ban trading in Russian bonds altogether would make it impossible for bondholders to deliver their defaulted bonds to CDS sellers, meaning the sellers could claim they shouldn’t cash out. WHEN CAN RUSSIA BE STANDARD AND DISABLE THIS PROCESS? The following Russian hard currency bond payments are two coupon payments or regular interest payments due on March 16. They have so-called grace periods of 30 days, meaning that formally would default on April 15th. However, the CDS determination committee has already been asked to look at what might happen for those bonds with the ruble fallback option. HOW MUCH MONEY IS ON THE INTEREST? Investment bank JPMorgan estimates that there is about $6 billion in outstanding CDS that should be paid out. But for investors who have bought insurance for their Russian bonds, it is likely that they will avoid a huge hole in their pockets. Some were even able to make a profit, as the fact that the default risk was considered extremely low before this crisis led to CDS being cheap.