Dreaming Of A CDS ETF

March 13, 2012

The CDS market is alive and kicking, which stokes my dream that a CDS ETF isn’t too far behind.

Last Friday, $3 billion worth of credit default swaps on Greece’s sovereign debt was triggered after the International Swaps and Derivatives Association ruling that Greece’s exercise of its retroactively imposed collective action clause qualified as a “credit event.”

ISDA’s ruling confirms the sovereign CDS market has a pulse, bringing relief to sovereign debt holders everywhere. It signals that CDSs can be an effective hedge against sovereign debt positions, something many in the market were beginning to doubt.

That’s great. But what about the little guy?

For those of us who aren’t institutional investors, how do we get a piece of the CDS pie in the form of ETFs that allow us to hedge our fixed-income exposure in a new way?

My question isn’t just rhetorical. Someone has thought of this and actually tried to get the SEC’s approval to move ahead. But it’s been a while.

In July 2008, San Francisco-based ETSpreads filed to market four CDS-centric ETFs. The proposed ETFs included two pairs of “tighten” and “widen” debt funds—one duo focused on investment-grade credits, the other pair on junk bonds.

The tighten funds are designed to increase in value as the credit quality of the underlying parties improves. Conversely, the widen funds are designed to increase in value as the credit quality of underlying parties deteriorates.

Never mind that the “N-1” registration statement is gathering dust at the Securities and Exchange Commission more than three years after ETSpreads filed it. The SEC hasn’t even granted ETSpreads the exemptive relief necessary to market such CDS funds, so the registration statement is truly a case of putting the cart before the horse.

Fund companies sometimes file registration statements before they get exemptive relief because they believe the approval to market particular types of funds will come quickly. That bet sure was wrong.

Further delaying—maybe even derailing—the idea was the SEC’s decision almost two years ago to stop granting exemptive relief to any companies whose ETF plans included the possible use of derivatives in their investment strategies.

That pretty much torpedoes the ETSpreads funds at least until the SEC completes its derivatives review, whenever that will be.

That said, I still think those CDS ETFs are a good idea.

So what does the future look like? Will we see credit default swaps available to retail investors in the form of an ETP, and how would investors use it?



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