Forget CDS: equity-default swaps return

IFR 2305 - 19 Oct 2019 - 25 Oct 2019
6 min read
Christopher Whittall

A rare and risky form of derivative insuring against stock market crashes is staging a comeback, as banks dust off the pre-crisis playbook in search of ideas to present to yield-hungry investors.

JP Morgan is at the forefront of banks building products using equity-default swaps this year, according to people familiar with the matter, with investors earning money by selling protection against a sharp decline in the share prices of a broad range of companies.

These derivatives have not been commonplace since the run-up to the financial crisis, when bankers first dreamed up the equity-market equivalent of the credit-default swap. Activity in “EDS” is still low, but a growing number of investors are turning to the product in this low-yielding environment, bankers say, with returns increasingly hard to come by elsewhere.

While minuscule in size compared with the US$8trn CDS market, equity-default swaps have one notable advantage over their more famous credit-market cousin: they offer a higher yield. Such deals allow investors to earn annual returns in the region of 3% to 4% for selling crash protection on a portfolio of 100 or so stocks, bankers say, assuming markets don’t fall off a cliff.

Equity-default swaps are in many ways much simpler products than CDS, which rely on a panel of banks and investors interpreting dense legal clauses to determine whether a company has defaulted or not. Instead, the performance of an equity-default swap simply references share prices.

In a typical trade, an investor will sell a deeply out-of-the-money put option (or the right to sell an asset at a pre-agreed price) with a barrier at 50% of a company’s current share price. Presuming the stock stays above that level over the life of the trade – usually 12 to 18 months – the investor collects their fee for selling the protection. If the stock hits that barrier, though, they will lose half of their investment.

So the investor’s bet isn’t too concentrated, they will sell protection of this kind on a portfolio of about 100 stocks, which could be picked out of the Stoxx Europe 600 benchmark index. That diversification should help reduce the risks of the trade, bankers say.

Such deals often appeal to private banking clients desiring a steady income over the next year or so who are convinced markets aren’t about to nosedive.


JP Morgan was at the forefront of creating the equity-default swap in the early 2000s in Japan. Jason Sippel, JP Morgan’s current global head of equities, was one of the executives instrumental in developing the product within the bank at that time, according to people familiar with the matter.

Then, as now, local investors wanted products promising chunkier returns than the measly yields available in bond markets. But in one important difference to that time, banks in the present day are no longer creating pools of equity-default swaps to slice up into an equity market version of complex synthetic collateralised debt obligations.

"Japan had a long history of low interest rates. Investors were looking for ways to get income and there was a greater acceptance of longer-dated structures," said Clarke Pitts, a now retired former JP Morgan executive, who was also involved in developing some of the first equity-default swap trades in the early 2000s in Tokyo.

“We created the concept of the equity-default swap not so that we could trade them directly, but so we could tranche the payoffs and do structured product-types of assets. The main intention of creating the equity equivalent of CDS was to support equity collateralised obligations, or ECOs," Pitts said.

JP Morgan was one of the first banks to sell CDOs linked to equity-default swaps to institutional investors in the early 2000s by slicing up portfolios of these derivatives into tranches with varying degrees of risk. One of those transactions was named "Geronimo” after a famously raucous "shot bar" in Tokyo.

But equity-default swaps – and CDOs linked to them – never reached the kind of huge volumes shifted in credit derivatives. The CDS market peaked at US$58trn in 2007, driven by the extraordinary expansion of structured credit products such as synthetic CDOs.

“It was always tiny compared with credit-default swaps, which was a colossal market,” said Pitts.


Bankers say the equity-default swap trades in the market today are a natural extension of other structured products in which investors effectively provide downside protection on equity markets. The popular “autocallable” product, as well so-called reverse convertible notes, both involve investors selling put options to earn returns.

“Equity-default swaps used to be popular before the crisis. There have been a few trades here and there, but we find there is more activity in the credit market,” said Kokou Agbo-Bloua, global head of flow strategy and solutions at Societe Generale.

Agbo-Bloua suggested it may make more sense to sell products that are better known to retail investors, such as autocallables on indices.

“It’s a lot easier to sell a product people are familiar with that has a long track record [rather] than going into a different payoff,” he said.