Sanctions complexity, tough US trade policy boosts risk for fund managers

Fund managers are facing increasing risks from the growing complexity of sanctions and an aggressive US trade policy. In more and more cases, enhanced due diligence is essential to determine whether an instrument has been issued by a company whose ultimate beneficial owner is a designated person or entity subject to restrictions or sanctions.

The current US administration’s America First trade policy could push more companies on to so-called “no trade” lists that make it riskier to buy their equity, debt and even derivatives. According to Oliver Bodmer, product management director at Six Sanctioned Securities Monitoring Service (SSMS) in Zurich, there have already been instances of companies moving from the no-trade list to becoming designated entities.

Frozen Russia ETFs

Fund managers should learn from the hard lessons of the exchange-traded fund (ETF) market, following Russia’s invasion of Ukraine in 2022. About 10 Russia ETFs worth an estimated $6 billion in total were either frozen, suspended or terminated when widespread sanctions were imposed.

The UK Financial Conduct Authority (FCA) created a ‘side pocketʼ regime in September 2022 to manage the problem by allowing funds to separate “problem assets” from the rest of the fund until issues are resolved. However, most investors in 100% Russia ETFs were left stranded by sanctions.

According to Six SSMS, in the past two years there has been a nearly 700% increase in sanctioned securities, which could rise depending on the outcome of US attempts to negotiate a peace deal between the Russian Federation and Ukraine. Russia-related sanctions could become ever more complex if the European Union and the UK take a different, tougher approach to Russia while the US seeks to warm relations.

Six SSMS has assessed more than 10,000 ETFs and found 7.7% included sanctioned securities. These ETFs are listed by issuers domiciled in China, the US and Ireland.

“What we see now is effectively that the some buy-side institutions that are constructing these ETFs probably do not do a proper sanction screening and constructs investment products that have a certain exposure to sanctioned securities,” said Bodmer.

Shell companies

He added that fund managers should be aware it is common for sanctioned entities to raise funds through offshore shell companies or other vehicles that are sometimes, but not always, designed to obscure ultimate beneficial ownership. All new issuance linked to a designated individual or company is restricted by sanctions.

“It can be that a sanctioned entity is using a shell company to issue a bond,” he explained. “These entities are issuing bonds in Luxembourg and the UK. But the bond has an ultimate borrower, the company that is effectively borrowing the funds, and this is written in the fund’s prospectus.”

Trade wars, sanctions risk

In 2020, under the previous Trump administration, an executive order prohibited “any transaction in publicly traded securities, or any securities that are derivative of, or are designed to provide investment exposure to such securities, of any Communist Chinese military company”. The People’s Republic of China, the order said, was using US pension investments to fund its military.

“Those companies raise capital by selling securities to US investors that trade on public exchanges both here and abroad, lobbying US index providers and funds to include these securities in market offerings, and engaging in other acts to ensure access to US capital. In that way, the PRC exploits US investors to finance the development and modernisation of its military,” it said.

The Trump administration is reviewing a Biden era rule that sought to restrict US investments in Chinese quantum computing, artificial intelligence (AI), and semiconductors and microelectronics companies. The Biden rule prohibited some transactions and made others subject to reporting requirements; the Trump administration wants to assess whether these limitations go far enough.

US trade policy has now become a conversation to be had with sanctions compliance and risk management teams.

“This compliance discussion is becoming more of a risk discussion,” Bodmer said. “If I show the compliance officer a trade restriction list, they will tell me: but it is totally legal, I can invest into them, right?” So he was now addressing risk managers at banks that might be heavily invested in companies subject to US trade restrictions, to point out the risk to the stock price if the companies were ultimately sanctioned.