IHS Markit is in consultation with the finance industry on the development of an ESG-linked credit-default swap index, according to sources familiar with the matter, a sign of how the industry is looking to tap into burgeoning demand for derivatives products related to sustainable investing.
Sustainable finance has expanded sharply in recent years as investors have become more focused on companies’ approach to environmental, social and governance issues. European investors poured a record €120bn into sustainable funds last year, according to Morningstar, while assets in these funds grew by 56% from the previous year to €668bn.
Despite the sharp growth in ESG-linked debt of late, there is currently no standardised derivatives contract allowing traders and investors to hedge their exposure to such investments.
IHS Markit could fill that void if it manages to create an ESG-friendly version of its widely-used iTraxx CDS indices. The data provider is in consultation with banks and investors over what an ESG-linked CDS index should look like following demand from the industry for such a product, sources said.
There is no firm timeframe for a product launch given the ongoing consultation process, the sources said. IHS Markit regularly discusses potential product ideas with the industry and there is no guarantee it will launch an ESG-linked CDS index, they added.
Still, many believe there would be sufficient demand for ESG-linked credit derivatives to take off.
“People are crying out for something [ESG-linked] they can sell,” said one banker.
Bankers are talking up the development of ESG-linked derivatives in general as one of the major themes of 2020 given the continued expansion of sustainable finance.
Sustainable debt markets have mushroomed in recent years as more companies have looked to bolster their ESG credentials. Sales of green bonds, a subset of ESG debt, rose 33% last year to US$176bn, excluding tax-exempt US municipal bonds, according to Refinitiv data.
LIQUIDITY FOCUS
CDS indices are a popular way for investors and traders to take positions and hedge risks in corporate credit markets, making them a natural candidate for bankers looking for ways to encourage more trading in products linked to ESG bonds.
About US$323bn in CDS indices have been traded on average each week so far this year, according to post-trade services firm Depository Trust & Clearing Corp.
The majority of that trading has focused on a handful of indices owned by IHS Markit. That dominance should put the data provider in a strong position to offer an ESG-linked CDS index if there is sufficient demand.
Sources said IHS Markit is consulting with the industry on a number of points related to the development of such an index, including selection criteria and how many names should be in it. Another question is whether it should be a subset of one of IHS Markit’s current CDS indices, or a new index altogether.
Whether a product can attract sufficient interest to gain traction among traders is likely to be critical to its success, one source said, given the tendency for CDS index trading to coalesce around a small cluster of contracts.
Just two CDS indices accounted for 67% (or US$224bn) of CDS index volumes in the week ended January 28. That was the latest versions of the IHS Markit indices referencing US and European investment-grade credit: CDX.NA.IG and iTraxx Europe Main, respectively.
“The development [of the market] depends on the liquidity of that ESG index,” a banker said.