The latest sanctions from the US Treasury Department froze assets from the Russian central bank and its ministry of finance, a move that may pose an unprecedented challenge to the plumbing that underlies several billion-dollar ETFs.

The new penalties introduced Monday “effectively immobilises any assets of the Central Bank of the Russian Federation,” the Russian Ministry of Finance or the country’s sovereign wealth fund in the US, according to a statement from the Treasury Department.

While investors can continue to trade the shares of ETFs and pooled investment vehicles holding Russian assets on US markets, the movement of Russian bonds in creation and redemption baskets has been abruptly halted.

“Trading in these funds, by the funds and with other institutions as counterparties would also be restricted, because the whole point is not to be able to move these Russian [assets] ultimately back into Russia,” said Eric Young, a senior managing director at compliance consultancy Guidepost Solutions.

Nearly $932m assets are in Russian sovereign debt or corporate debt issued by companies hit in last week’s sanctions, according to FactSet data.

This poses a conundrum for ETF custodians, financial groups that hold an ETF’s underlying assets and act as an integral part of the creation-redemption process that allows ETFs to trade intraday.

Representatives from Brown Brothers Harriman, US Bank and BNY Mellon declined to comment, citing the rapidly evolving nature of the situation.

Foreside declined to make a representative available for an interview, but in a statement said it is monitoring changes to the SWIFT payments system made in the past few days to restrict the flow of assets in and out of Russia.

“We are hearing from certain global custodians that the SWIFT sanctions which have been announced will take time to be implemented and information on how the sanctions will be enacted is dependent on SWIFT. When these sanctions are implemented, SWIFT will likely remove sanctioned entities from the platform,” the firm said. 

While ETFs have had to deal with disruptions in pricing before, such as when Van Eck Global halted creations for the VanEck Egypt Index ETF (EGPT) for nearly two months during the country’s revolution and subsequent stock market closure in 2011, this may be the first time that a specific group of securities held by ETFs have been frozen. 

Active ETF managers may have been able to dump their positions in the past few weeks, but index-based funds have had to maintain their positions. That will likely incur higher-than-normal tracking error between a fund’s price and its net asset value. 

Some funds may have to hold onto this tracking error for the rest of the month. ICE Indexes announced on Monday it would remove all sanctioned debt from its indexes on its March 31 rebalancing.

“This will make it harder to run the ETF, and harder for the ETF to be able to trade in line with its net asset value,” Todd Rosenbluth, director of ETF and mutual fund research at CFRA, said. “How much harder? I do not know.” 

The path forward for these ETFs is uncertain, but there may be some hints in their prospectuses listing potential risks, Kip Meadows, CEO of fund advisory group Nottingham, said. 

For example, the $17bn iShares JP Morgan USD Emerging Markets Bond ETF (EMB) is allowed to halt in-kind transactions and instead use cash, but such a move would increase transaction costs for shareholders.

A spokesperson for BlackRock was unable to provide a response before publication time when asked by ETF.com if the firm was planning to halt in-kind transactions for funds with sanctioned assets.

This story was originally published on ETF.com

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