NEW YORK (Reuters) - ProShares has filed with the Securities and Exchange Commission to launch a number of exchange-traded funds backed by credit default swaps, as new regulations for the privately traded contracts reduce some of their risks and open the market to new types of investors.
Derivatives markets are adapting to new regulations designed to reduce the risks these contracts pose to the financial system after their opacity, high concentration among the world’s largest banks and lack of collateral pledged against the trades were cited as key factors behind the 2007-2009 financial crisis.
The new rules are meant to help open the markets to new competition, and have resulted in new, alternative product launches, including plans for listed credit futures. They are also opening the market to a wider range of investors.
There have been several attempts to launch credit products as alternatives to the privately traded CDS market, which is limited to institutional trades of very large size, though none have so far caught on.
That may be starting to change, however, as more trades are moved to central clearing-houses, a shift that removes the exposure of investors to the credit risk of the bank doing the trade and frees up trading to a larger group of participants.
At the same time, retail investors may be reluctant to enter products backed by credit default swaps, which remain tainted by their role in the crisis, when they were used in structured vehicles backed by risky mortgage-backed debt.
“Central clearing makes it much simpler to launch new products, but there is some concern about the CDS market. It may take education for retail to understand it,” said Peter Tchir, founder of advisory firm TF Market Advisors and a former credit derivative trader.
Funds backed by CDS may nonetheless hold appeal as they offer investors the ability to bet on credit quality, without having any exposure to the interest-rate risk present in corporate and other bonds.
Treasuries yields surged in May after comments by Federal Reserve Chairman Ben Bernanke stoked fears that the Fed may begin to reduce its unprecedented stimulus, a shift that many investors worry will send rates substantially higher.
“Investors need income but would prefer to take spread risk rather than yield risk,” said Tchir.
ProShares filings include proposed launches of eight CDS ETFs that will go long or short, respectively, North American and European high grade or high yield credit.
The funds will be based on trades on credit derivatives indexes that are centrally cleared, or on exchange-listed futures, depending on their respective liquidity, Proshares said in the filings, made on Friday.
Global outstanding volumes on privately traded credit derivatives have declined to $26 trillion at the end of 2012, from $30 trillion at the end of 2010, according to the Bank for International Settlements.
Editing by Dan Grebler