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Russia's President Vladimir Putin appears on a television screen at the stock market in Frankfurt, Germany, on Feb. 25.Michael Probst/The Associated Press

Short sellers have scored a huge year-to-date gain of US$723-million on dozens of Russian stocks listed on foreign exchanges as ADRs or GDRs, according to a report from S3 Partners Research. But the short sellers can’t cash in on their good fortune and claim their winnings just yet; by the time they get the chance, a considerable portion of their gains may have gone up in smoke.

ADRs and GDRs are American depositary receipts and global depositary receipts, which are created by banks when they purchase stocks in one country and issue receipts to represent them on exchanges in another country. The banks hedge out the currency fluctuations, allowing foreign investors to purchase the receipts in their own currencies.

Selling short Russian ADRs and GDRs was a smart move that correctly anticipated the plunge in Russian stocks triggered by international sanctions levied against Russia for invading Ukraine. Alas, one can get the direction right but the timing wrong.

As Russian stocks spiralled downward, authorities closed the Moscow stock exchange on Feb. 24, followed in the days afterward by the halting of trading in many Russian ADRs and GDRs listed in the United States, Britain and other countries. As a result, investors who were long the ADRs/GDRs could not sell them, and short sellers could not buy the ADRs/GDRs to return the ones they had borrowed to sell short.

Top 20 Russian ADR/GDR Shorts (03/03/22)

Ozon HoldingsOZON-US$73,490,826
Mobile TeleSystemsMBT-US$30,511,635
Polymetal IntlPOYYF-US$13,178,943
MNC Norilsk NickelNILSY-US$5,398,913
HeadHunter GroupHHR-US$5,367,033
Rosneft Oil Co.OJSCY-US$2,926,578
United Co Rusal486-HK$2,859,314
Novatek NOVKY-US$2,692,172
VTB BankVTBR-L$2,684,288
MMC Norilsk NickelMNOD-US$1,823,568
Polyus PLZL-L$891,060
Total Russian ADR\GDR$194,778,645

Source: S3 Partners Research

The top 20 short positions in Russian ADRs/GDRs, shown in the accompanying table, accounted for nearly all of the total short position. Two years ago, the total short position was close to US$1.2-billion. The large decline since then does not reflect a drop in bearish bets by short sellers – they actually increased somewhat in 2022. Instead, it reflects the downward trend in the prices of Russian ADRs/GDRs, with most of the tumble coming in 2022 when prices went into a freefall.

“Russian ADR/GDR short sellers are sitting on a large amount of unrealized profits, but they are not bankable until their trades are closed out and profits are realized,” Ihor Dusaniwsky, a managing director at S3 Partners, noted in a report. “With trading halted in many securities and liquidity in tradable stocks limited … shorts sellers, as well as long shareholders, may be stuck in their positions until trading reopens in many of these securities.”

However, short sellers also face rising borrowing costs on the ADRs/GDRs they borrowed to go short. Even though trading is suspended, borrowing costs can still rise because the securities-lending market remains open, functioning on an overnight basis with lending rates set each day.

During those daily sessions, as Mr. Dusaniwsky said in a telephone interview, “one thing that could happen is that securities lenders will seek higher lending rates from short sellers since they know they have few options to borrow elsewhere given the limited number of ADRs/GDRs available for lending.”

“Another one of the possibilities is that long investors may also engage in off-market transactions to sell their holdings to another investor,” Mr. Dusaniwsky said. “This can reduce the number of shares available for lending and put further upward pressure on the cost to borrow.”

Thus, even with trading suspended, borrow rates can rise for several reasons and take a substantial bite out of mark-to-market profits. “We are already seeing borrow rates starting to rise,” Mr. Dusaniwsky said. “As more long shareholders exit their positions, the borrow pool will continue drying up and borrow rates will increase.”

Larry MacDonald writes at Investing Journey

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