On Jan. 11, ESMA issued working paper on hedging and trading.
ESMA issued Working Paper No. 1, 2021, named Funds and Single-name CDS: Hedging or Trading?, looking at the use of single-name credit default swaps (CDS).
Overview
The use of derivatives by investment funds is of particular interest for several reasons. While the use of derivatives by banks is well documented, evidence relative to investment funds is more limited but is key to address potential financial stability risks.
Research is focused on role of non-banks in global markets, including in derivatives.
Derivative instruments can be categorized according to their underlying asset classes including elements like equity, credit, interest rate, commodity and foreign exchange.
Some data sets used for the paper are taken from those produced in EMIR reporting.
Credit Default Swaps
CDS are instruments used to transfer credit risk of an entity from one party to another. In these cases a protection seller agrees to make a payment to a protection buyer in case of a credit event, a legally defined event that, typically, includes bankruptcy.
This is agreed on a pre-specified reference entity and in exchange for this promised payment, the protection seller receives a periodic premium payment from the buyer.
Working Paper Content
The paper offers a comprehensive view of drivers behind the use of single-name credit default swaps by UCITS investment funds, utilizing EU regulatory data on derivatives.
It looks at fund characteristics associated with use of single- and multi-name CDS, and fixed-income and alternative funds are 10x more likely to use CDS than other funds.
Funds belonging to a large fund family are also 75% more likely to use CDS, mainly as net sellers, exposing them to significant credit risk and raising spectre of moral hazard.
Matching single-name CDS positions with portfolio holdings of users, shows that funds hold underlying bond in 50% of cases for sovereign CDS, and 30% for corporate CDS.
Looking in particular at buy-side positions, the research found that only around 5% of single-name CDS positions actually match the specific market exposure from the bond.
Conclusions
Results do question claims that main purpose of single-name CDS by funds is hedging.
The very small share of CDS that are used exclusively for hedging the full market exposure of a bond raises question as to the motivation behind their use by UCITS.
Combining this with the net sell CDS exposure, does raises supervisory concerns from an investor protection and financial stability perspective, in any highly volatile period.
