Wednesday, September 5, 2018 Stamford, CT USA — The shrinking popularity of credit default swaps has left investors in search of an effective tool for managing credit exposures and risk.  In fact, a new study from Greenwich Associates shows that CDS, the traditional hedging product pioneered in the 1990s, have fallen behind ETFs in popularity as investors’ tool of choice for managing credit exposure.

In the wake of the global financial crisis, regulators enacted sweeping reforms of the CDS market, which played a role in transmitting credit risk around the financial system with remarkable speed and incredible scale. While these reforms have reduced the level of counterparty risk, they have also had the effect of reducing liquidity and the utility of the CDS itself.

In a recent Greenwich Associates study of credit market participants, 67% said managing volatility was their top priority and ETFs were the group’s preferred tool for gaining credit exposure.  Forty percent of study respondents viewed ETFs as the best method for gaining credit exposure vs. 27% for index and 22% for single name CDS. 

“Market participants have been forced to make a trade-off between liquidity and specificity and they’re choosing liquidity,” says Ken Monahan, Senior Analyst in Greenwich Associates Market Structure and Technology practice and author of Credit Hedging Products: A New Focus on Risk Spurs Demand.

A majority of investors are unsure about the prospects for a CDS revival and cite a lack of interest from the sell side, unsupportive regulations, lack of a CCP, and a lack of incentives for liquidity providers to make markets. Among those expecting the market will recover, nearly two-thirds believe that the regulatory environment will improve, leading dealers to commit more capital.

“It’s surprising to see the focus shift to risk management, given the relatively benign current environment,” says Ken Monahan. “But with the considerable scale of issuance that has occurred during this lull in volatility, this period of calm will not last forever.”