ESMA: What drives the use of CDS by EU investment funds?

20 September 2018

As part of ongoing efforts to improve the monitoring of derivatives markets, this article investigates the drivers of credit default swaps usage by UCITS investment funds.

ESMA presents several important findings: only a limited number of funds use CDS; funds that are part of a large group are more likely to use these instruments; fixed-income funds that invest in less liquid markets, and funds that implement hedge-fund strategies, are particularly likely to rely on CDS; and fund size becomes the main driver of net CDS notional exposures when these exposures are particularly large. This article also explores the bond-level drivers of funds’ net single-name CDS positions. We find that CDS positions on investmentgrade sovereign bonds – most of which are from emerging market issuers – tend to be larger. The analysis finally sheds some light on tail-risk from CDS for funds: directional strategy funds that belong to a large group are the most likely to have sell-only CDS exposures, exposing them to significant contingent risk in case of default of the underlying reference entity. Similarly, a number of funds use CDS to build unhedged credit exposure to US non-bank financial issuers.

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