The Russian Delisting Dilemma: Red Herring, Nightmare or Both?

What are depositary receipts?

DRs are instruments used for investing in international equity markets. They are negotiated securities issued by a bank that represent shares in a foreign country’s company — in other words, a stock of a stock with customizable regulatory oversight and segmented liquidity.

During times of market and geopolitical stability, these tools allow firms to increase their productivity by enabling them to tap additional capital for investment. Diversifying their sources of capital also improves the resiliency of business models by providing a hedge against concentration and region-specific risks. 

After the Russia/Ukraine war began earlier this year, however, several western exchanges, including in the United States, stopped trading in Russian DRs (known as ADRs, short for American Depositary Receipts) as part of the sanctions against Russia. This action led Russia’s parliament to implement this Federal Law No. 114-FZ.

The delisting process and its pitfalls

Under the new federal law, companies had five business days (i.e., until May 5) to make “necessary and sufficient” measures to terminate their depository receipt program deposit agreements. In the wake of the delisting of Russian DRs, investors and issuers alike are left with a finite number of options.

The base case is a conversion to Russian-listed shares of the firm associated with the DR held, but there are other avenues worth surveying. Given the nature of DR agreements, issuers and investors have varying loptions to cancel the DRs, although this is highly dependent on case-specific circumstances. Russia has included the potential for exemptions to this new federal law, which could conceivably brunt the impact of the delisting.

As Russian firms have worked to comply with the law, there have been some key developments to consider with each of the scenarios outlined above. On April 27, 2022, the Central Bank of Russia placed restrictions on selling shares received from DR conversions (conversion shares). Extending to both exchange-traded and over-the counter transactions, no more than 0.2 percent of the conversion shares held at any custodian may be sold in a single trading day. These restrictions result in significant uncertainty for the timing and ability to liquidate local shares received in the event of conversion.

Issuers have also had mixed success in applying to maintain their DR programs. Numerous exemptions have been granted, but typically for small, less systemically important Russian companies. For example, Gazprom, Russia’s largest state-owned energy company, was denied for exemption and as a result will delist their DRs. In companies that were granted exemptions, defensive strategies are being discussed to source capital from other markets and refine where DR programs are maintained. For companies that were granted exemptions and wish to maintain their existing DR programs, the DR holders are restricted from receiving dividends or exercising their voting rights in relation to their underlying ownership.

Most U.S. investors have little Russia exposure

So, what is the significance to domestic investors in a worst-case scenario?

At this time, only broad approximations can provide a sense of what could occur if DR holders abroad were to receive local listings, maintain their DRs through exemptions with the potential to see their values fall or write-off the full value of their Russian DRs.

The good news is that it appears that most U.S. investors will not have to worry much about the situation, because overall exposures for both institutional and individual investors and potential absolute losses are small.

Using public investors as an example (and because the information is public), it is informative to examine the portfolios of large public pensions in the U.S. When looking at three of the largest public pension systems — the California Public Employees’ Retirement System, the New York Common Retirement Fund and the Washington State Investment Board — their exposures as a percentage of their total portfolio span approximately 0.04 percent to 0.15 percent. Overall, Russian investments represent only a very limited portion of public portfolios.

Modern pension schemes, in general, apply thoughtful care to asset allocation, emphasizing diversification as well as measurement and management of risk at the portfolio level. The presence of these principles being carried out in public pension funds has resulted in a relatively minimal overall headwind to be faced by the delisting of Russian DRs.

These trends translate over to individual investors, who commonly are invested for retirement through DC plans. Within these plans participants are offered a range of investment options to select, with a default option if an investor chooses not to construct a personal portfolio — the Qualified Default Investment Alternative (QDIA). According to PLANSPONSOR's 2021 DC Plan Benchmarking Survey, 77 percent of plan sponsors responded that they provide a target date fund as their QDIA on average. That percentage increased to 91 percent for plans with over $1 billion in assets.

As reported by Morningstar, the top five target date fund providers at the end of 2021 collectively managed about 79 percent of the assets in the target-date market. These firms were: Vanguard, Fidelity, T. Rowe Price, BlackRock and American Funds. The “Europe Emerging” category captures geographical equity exposure to Russia, Ukraine and 19 other countries within close proximity. The level of regional exposure to this “Europe Emerging” category offers hints at the sensitivity the target date funds have to Russian assets and other assets significantly impacted by the Russia-Ukraine conflict.

Using three target date categories that represent a cross section of individuals (in or near retirement, midway through their careers and far from retirement), to evaluate exposures, we selected target date funds of 2025, 2040, and 2060. The five providers’ average exposure to “Europe Emerging” securities was 0.51 percent, 0.48 percent, and 0.49 percent respectively. The maximum exposure level for any provider or vintage was 1.23 percent, while the minimum was 0.16 percent.

Expanding beyond these top five providers, the category averages Morningstar provides for these regional exposures become even smaller. Across all products included in the target-date 2025 category, exposure averages 0.22 percent. Similar peer groups for the 2040 and 2060 vintages average 0.27 percent and 0.30 percent exposure respectively. Thus, overall, it appears that institutional investment products directed towards retirees can expect portfolio impacts from the delisting of Russian DRs of under 1 percent.

Taken as a whole, there is considerable evidence that America’s retirees will be able to continue saving for their retirements with little effect from the decision of Russia to delist their global DRs.

While this is encouraging, it must be acknowledged that the conflict is evolving and unpredictable. The impact that the conflict has on a specific plan or plan participant should be continually monitored.