The Present Value

ISDA highlights a selection of research papers on derivatives and risk management         


Credit Default Swaps and Corporate Board Trading

Bank of England Staff Working Paper No. 810
By Robert Czech

The paper examines the connection between liquidity in the credit default swaps (CDS) and corporate bonds markets, and provides evidence for a positive spillover effect from CDS to corporate bond trading. The author suggests that a well-functioning single-name CDS market contributes to higher corporate bond trading volumes and greater number of bond buyers.

The study is based on Depository Trust & Clearing Corporation trade repository data on monthly single-name CDS positions and regulatory data on corporate bond transactions from the Financial Conduct Authority’s Zen database. The analysis shows that investors with active CDS contracts on a particular issuer are associated with 60% higher buy volumes in the bonds of the reference entity, compared to non-CDS counterparties. However, severe CDS mark-to-market losses can cause fire sales in the corporate bond market, which lead to a significant drop in bond returns.

The study also points out that regulations that increase costs of CDS transactions are likely to have a negative impact on bond trading, while the shift to central clearing improves the efficiency and transparency of the single-name CDS market and has positive implications for the corporate bond market.

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Who Sees the Trades? The Effect of Information on Liquidity in Inter-Dealer Markets

Federal Reserve Bank of New York Staff Report No. 892
By Rodney J. Garratt, Michael Junho Lee, Antoine Martin, and Robert M. Townsend

The paper examines how the availability of information affects overall market liquidity in decentralized asset markets with a tiered trading structure (the first stage involves a trade between dealers and traders – the market-making stage – and the second stage involves trade between dealers – the interdealer market). The authors suggest that dealers are subject to both liquidity and adverse selection costs and interdealer trading increases when the benefits of liquidity management outweigh adverse selection costs.

The study finds that full disclosure of information on trades in the market-making stage increases overall liquidity. However, if only a subset of dealers is informed, it creates asymmetric information and leads to less liquidity than the no disclosure case. The authors note that the worst possible case of partial information disclosure emerges in an environment where post-trade information is sold by a strategic platform.

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The Impact of Central Clearing on the Pricing of Sovereign Credit Default Swaps

By Josephine Molleyres and Heinz Zimmermann, University of Basel

The paper provides an empirical analysis on the impact of central counterparty (CCP) clearing on sovereign CDS spreads. The analysis is based on a sample of five-year sovereign single-name CDS spreads of 13 countries.

The study shows that CCPs mitigate counterparty risk, implying that sovereign CDS spreads are no longer dependent on the default probability of the major CDS dealers. However, central clearing has no effect on CDS market liquidity. The authors state that CCP clearing has a dual effect on liquidity. On the one hand, the bid and ask quotes of CDS trades reflect the direct and indirect costs imposed by CCPs for their risk managing services, which might negatively affect CDS market liquidity. On the other hand, the more transparent and less risky nature of centrally cleared trades, coupled with improved operational efficiency, could lead to increased competition and reduced liquidity shortages in over-the-counter markets, which would lead to lower bid-ask spreads.

Additionally, the study finds that CDS spreads are mainly driven by country-specific characteristics as opposed to global factors. In particular, a depreciation of local currency increases CDS spreads, while a country’s positive stock market performance, proxied by the local MSCI returns, would result in tighter CDS spreads.

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