ETFs, Financials Feel Pain of Credit Swap Market

The failure of big banks has been detrimental to the credit default swap market, but how has it influenced the exchange traded funds (ETFs) that track the big insurers that create these swaps?

In layman’s terms, a credit default swap (CDS) is a credit derivative contract between two counterparties, in which the buyer makes payments to the seller and in return receives a payoff if an underlying financial instrument defaults.

The beauty of this innovation was that investors didn’t mind owning corporate debt which, in turn, lowered the cost of capital.  The failure of big banks and American insurers, such as AIG (AIG) and lack of transparency resulting in no one really knowing the extent of investors exposure to CDS’s has lead to the demise of the CDS, states the Economist.

Some argue that the CDS should be completely abolished, while others believe that reform is the next step. It may take years before the markets can view CDSs with some perspective.

The impact of the CDS market is far-reaching. Among ETFs impacted in one way or another include:

• SPDR KBW Insurance (KIE): down 51.49% year-to-date

• iShares Dow Jones US Insurance (IAK): down 55.52% year-to-date