Ukraine’s "Conflict Derivatives" Are About to Explode
How an Obscure Financial Instrument Exposes Europe's Lack of Hard Power
Markets have a brutal habit of delivering honest signals, especially to governments that prefer to ignore them. They reveal whether policies align with reality or just with wishful thinking.
In the Soviet Union, bribery chains emerged as central planning couldn’t meet basic needs. Supply and demand still ruled, just off the books. In post-war Germany, cigarettes replaced the official currency, signaling that the Reichsmark was worthless. During Prohibition in the U.S., the mass production of bootleg alcohol exposed the futility of trying to legislate away human behavior.
No matter how noble the intention, markets rip off the mask. A signal from an unexpected corner is now about to confirm something the EU doesn’t want to hear: believing in the right values doesn’t make you a global force. In realpolitik, it’s not ideals that matter, it’s power. At the heart of it is an obscure financial instrument, buried in a debt deal struck a decade ago.
Hedge Funds vs. Ukraine
The story starts in 2015, when Ukraine’s economy was in freefall. After Russia’s annexation of Crimea, GDP shrank by nearly 10% and the hryvnia lost a third of its value against the dollar. Ukraine defaulted on $3 billion it owed to Russia and scrambled to cut a deal with Western creditors. They agreed to write off 20% of Ukraine’s debt and in return got something exotic: GDP warrants.
These GDP warrants are not traditional bonds that pay interest or principal. They only kick in if Ukraine’s economy grows fast enough. Specifically, once annual growth hits 3%. In 2023, Ukraine’s GDP exceeded that threshold by growing 5.3%.
Of course, that growth wasn’t the result of a booming economy. It was a rebound after Ukraine’s GDP had cratered by nearly 30% following Russia’s invasion in 2022. But the formula in the bond contract doesn’t care about context. Growth is growth. And the funds want their money. The owners of those GDP warrants—among them hedge fund giants like Aurelius Capital Management and VR Capital Group—demand $542 million by June 2.
Ukraine has already pushed back, announcing it will temporarily suspend payments on the warrants. It argues that paying out half a billion dollars in the middle of an existential war is both unjust and unworkable. Instead, Kyiv offered a fresh restructuring: a new round of bond swaps that would push payments further down the road.
It’s the sovereign debt version of inviting someone to dinner and then asking them to cover the tab you skipped last time. Let’s unpack the scenarios ahead, and why Europe may soon pay the price for a deal it never signed but enabled.
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Black Swan or Bad Bet?
There are two ways this can go: Ukraine might strike a settlement with the warrant holders or it could default.
If Kyiv walks, the hedge funds sue. The case could go to an English court or an arbitration panel, depending on the jurisdiction clause. In either forum, the key question will be: did the war-triggered GDP rebound qualify as a black swan or was it foreseeable?
The bondholders position is clear. They want their money, which means they don’t accept the war as an unforeseeable disruption. Finance Minister Serhii Marchenko describes the warrants as "designed for a world that no longer exists.” So were these GDP warrants naive peacetime optimism or just badly negotiated financial engineering?
Here’s the ground truth: In 2015, Ukraine was already at war. Russia had annexed Crimea and the Donbas conflict was raging. The Minsk II agreement was signed that February but no one really believed in its staying power. Ceasefires were violated regularly. Even back then, escalation wasn’t some outlier risk.
The rebound Ukraine experienced wasn’t surprising either. Countries emerging from deep economic shocks—like post-Yugoslavia or post-war Germany—often show strong nominal growth because the baseline is so low. Ukraine isn’t post-war, but even amid conflict, a partial rebound was plausible, especially with consistent EU and Western backing. Against that backdrop, it’s fair to assume that everyone involved understood the lenders’ real bet: “There’s a chance Ukraine collapses. That’s our downside. But if it holds and rebounds we’ll take the upside.”
For then-president Petro Poroshenko, the deal made sense. Ukraine was neck-deep in crisis, and Poroshenko—more focused on preserving his own wealth than securing long-term financial resilience—was desperate for a quick fix. The lenders saw an asymmetric upside opportunity. And Europe? It may not have signed the GDP warrant deal but it’s inextricably tied to the outcome.
Moral Hazard Alert
Foreign aid has been essential in plugging Ukraine’s fiscal holes. With tax revenues gutted by war and defense spending eating up what’s left, the country is nowhere near solvent on its own. If Kyiv pays the hedge funds, it won’t be Ukraine paying, it’ll be Western donors footing the bill. But if Ukraine doesn’t pay? Then things get even worse.
A default would send Ukraine’s borrowing costs through the roof. Investors would flee and new capital would dry up. If, as a consequence, the government can’t fund basic services—schools, hospitals, pensions—then Europe will end up paying anyway. Not through bond markets, but through crisis response, emergency aid, and migrant waves that will come with both political and economic costs. It’s telling that the European Commission refuses to back Ukraine’s position. A spokesperson said:
The Commission has been closely following the negotiations between Ukraine and the holders of the so-called GDP warrants and will continue to monitor these exchanges going forward.
In other words: it won’t support Ukraine defaulting but it also won’t promise to foot the bill. Because taking either side would set a precedent the EU can’t afford. Endorse the default, and Ukraine’s creditworthiness collapses. Refuse the default, and the EU effectively signals bailout readiness.
That creates a textbook moral hazard: encouraging reckless bets on the assumption Brussels will always step in. So instead, it says nothing and hopes the problem resolves itself. Of course, this entire situation wasn’t unforeseeable. So why didn’t the EU, a close ally with skin in the game, push for a war clause?
Virtue Signaling Backfire
It’s tempting to chalk this up to a colossal negotiation blunder, another case of incompetence. But it’s hard to believe that no one in Brussels flagged the risk of a post-conflict GDP rebound triggering massive payouts.
Having seen my fair share of memos ignored for clashing with the political line, here’s a plausible explanation: EU leaders were overconfident. They didn’t want to admit that escalation was a real possibility, so they acted as if it wasn’t. As the then–President of the European Council Donald Tusk proclaimed in 2015:
The European Union has been supporting Ukraine in its ambitious, and absolutely crucial, agenda of political and economic reforms. […] Europe will stay the course. Ukraine must stay the course of reforms. And Russia must change its course.
As if repeating pro-democracy catchphrases on loop would make Russia back down, dazed and disarmed by the blinding light of Brussels' moral superiority.
A decade later, the EU is now stuck cleaning up the mess and the hedge funds are ready to collect. The lenders understood from day one: their downside risk was limited. If Europe kept its support, the payout would be enormous. In other words, the real bet wasn’t on Ukraine’s economic fundamentals. It was on the West’s political resolve. And that bet looks likely to pay.
“Conflict Derivatives”
For Kyiv, and by extension for Europe, renegotiating is the only hope. A courtroom loss would mean paying out in full. Once the temporary cap lifts, the costs will escalate fast. Until next year, the annual payout is limited to 0.5% of GDP. After that, the gloves come off. If GDP growth hits 4% or more, warrant holders claim 40% of the extra. These instruments run until 2041 and could be worth tens of billions by then.
Whether by design or not, these GDP warrants turned out to be an unusual bit of financial engineering. They let investors bet not just on a country’s economy but on its alignment with the West. Let’s call them “conflict derivatives”: high-upside trades that pay off if the West steps in. Which makes you wonder: what country gets the next round of conflict derivatives? Georgia, Moldova, or Armenia?
In an ideal world, these warrants would serve as what they truly are: disciplining tools. Mark-to-market referenda on the EU’s strategic overreach and its belief that moral values can substitute for hard power. But don’t hold your breath.
Stapling Weaknesses
Instead of treating signals as opportunities to rethink its approach, Brussels prefers to stick with more of the same (“n+1 incrementalism” as
calls it): The EU just rolled out its 17th sanctions package against Russia, because, as everyone knows, the 17th time’s the charm.And just days ago, Ursula von der Leyen was fantasizing about expanding the bloc to include Ukraine, the Western Balkans, Moldova, and “hopefully” Georgia, calling it a “historic reunification.” As if stapling a handful of fragile economies onto the Union will somehow fix its foundational weaknesses and finally turn it into a real geopolitical superpower.
The sad truth is that the world isn’t bending to Europe’s values, no matter how many times they’re repeated. Too bad no one in Brussels seems to remember how to read a price chart.
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As peace talks founder, and the Russian army continues to advance, western investors in Ukrainian assets, whether debt, equity, or real property, must be growing increasingly anxious.
I think the numbers are going to prove far too great for the EU to underwrite, and a lot of unhappy investors will be left holding claims on a country that no longer exists.
Not easy to feel sorry for them.
What a great article .. no surprise that the investors are a whole lot smarter than the Euro bureaucrats