Single-name credit default swaps (“CDSs”) are derivatives based on the credit risk of a single borrower such as a corporation or sovereign. Although the single-name CDS market expanded rapidly during the period of loose monetary policy and expanding credit from 2002 through 2007, its growth began to slow after the global credit crisis and during the Eurozone sovereign debt crisis in 2010 and 2011, after which the single-name CDS market began to contract. In recent years and despite deliberate efforts by the International Swaps and Derivatives Association (“ISDA”) and market participants on both the buy and sell sides, the single-name CDS market shifted from stagnating growth to an actual contraction and has shrunk substantially. At its high-water mark in June 2011, the total notional amount outstanding on single-name CDSs based on corporate and sovereign borrowers was $15.4 trillion. By June 2015, notional outstanding had collapsed to $6 trillion – i.e., a contraction of 61 percent over four years.
Several possible reasons may explain the recent decline in single-name CDS activity. One possibility is that the current environment of relatively low interest rates and default rates has reduced the demand for hedging and synthetic bond investments (a.k.a. taking a position on the credit risk of a borrower) using CDSs. Another oft-cited potential explanation for the post-2011 contraction in the single-name CDS market is the panoply of changes to the global financial regulatory framework, such as margin and capital requirements on cleared and non-cleared swaps and the ban in the E.U. on short selling using sovereign CDSs. Such regulatory changes have already reportedly raised costs and decreased demand for single-name CDSs (or for hedging entity-specific credit risk altogether) even though many regulatory initiatives have still not been implemented in final form.
Some skeptics of single-name CDSs believe that the products themselves may have been defective prior to some of the reforms undertaken following the credit crisis and Eurozone sovereign debt crisis. Indeed, despite any significant evidence, a few commentators maintain that CDSs were either a cause or significant source of amplification for the credit crisis that migrated from U.S. subprime and leveraged finance markets to the global credit system beginning in August 2007.
To provide a more widespread and better understanding of the benefits and costs of single-name CDSs, we were commissioned by ISDA to prepare a review of the empirical academic literature on these products. Specifically, we restricted our review to single-name CDSs based on corporate and sovereign borrowers and did not consider the research on multi-name and/or index CDSs, loan CDSs, or CDSs based on asset-backed securities. The scope of our review included empirical research published in peer-reviewed academic journals, quasi-academic/trade journals with largely academic editorial boards, and working papers distributed through the Social Science Research Network (“SSRN”), universities, and the research divisions of financial regulators (e.g., the Bank for International Settlements, European Central Bank, and Federal Reserve). Our review did not include a survey of industry research, articles in industry and trade magazines or journals, and mainstream media publications. Although we have made every effort to be comprehensive and reviewed more than 260 empirical studies, comprehensive is not synonymous with exhaustive, and we offer our apologies for any research we might have missed.
To frame our literature review and analysis, we considered four major subject areas into which most single-name CDS research can be divided:
(a) The informational content and determinants of single-name CDS spreads;
(b) Implications of single-name CDS trading for lenders and reference entity borrowers;
(c) Relations between single-name CDS markets and related debt and equity markets; and
(d) Single-name CDSs, interconnectedness, and systemic risk.