Essec Business School

Laurence Lescourret and Andras Fulop received the Best Paper Award on Derivatives (sponsored by the IFSID, Montreal Institute of Structured Finance and Derivatives), during the annual meeting of the Northern Finance Association, for their article "Transparency Regime Initiatives and Liquidity in the CDS Market."

In the days before credit default swaps, banks were dealing with a critical risk management problem: while they were lending tens of billions of dollars to corporations, they had no means of offsetting the risk of default on these loans, and were having to keep huge amounts of capital in reserve as a result. Then, in 1994, JP Morgan came up with the idea that would help protect banks from the risk of default of corporate borrowers while freeing up that capital.

As they were initially designed, Credit Default Swaps (CDS) acted much like insurance contracts for bank agents: A CDS purchaser (the insured) would pay fees to the seller (the insurer) and in return be compensated in the event of a default. However, CDS were different from insurance policies in two critical ways:

• First, CDS purchasers didn’t need to have any financial stake in the reference entity - it was kind of like insuring your neighbor's car and getting paid if your neighbor got into an accident;
• Second, CDS were (until recently) very lightly regulated and exempt from supervision - they were a typically opaque, over-the-counter derivative market.

These distinctive features made them immediately and  immensely popular with investors as an easy way to maintain a steady return with minimal risk. But in some ways, the CDS market was a victim of its own popularity: at its peak - the market reached $58 trillion in 2007 - traders were using CDS contracts to speculate on the future performance of various mortgage securities, including subprime mortgages.

The end of the housing bubble spelled disaster: AIG alone found itself on the hook for $440 billion in debt written on CDS contracts, including over $57 billion on subprime mortgages, which the otherwise profitable company to the brink of bankruptcy. And since the opacity of the CDS market made it impossible to predict the consequences an AIG default would have on the financial system, the US government then found itself in a position where it had no choice but to bail out AIG for a staggering $85 billion.

Restoring investor confidence

The global financial crisis of 2008 shook the foundations of the financial system to the core. In the weeks following the AIG bailout and the Lehman collapse, the market faced a period of slow-down due to the lack of transparency on open CDS positions. In an attempt to improve the market’s viability and restore investors’ confidence, substantial changes in the CDS market started to be made and the end of 2008 and in 2009:

• First, on October 31, 2008, the Depository Trust & Clearing Corporation, that supports the post-trade processing of over-the-counter (OTC) derivatives contracts, unilaterally decided to make available at no cost weekly aggregated post-trade data to regulators and the public from its Trade Information Warehouse. Disseminating this data was a first step to address market concerns about post trade transparency.
• Second, in 2009, CDS trading changed considerably with the implementation of the Big Bang in the US, and the Small Bang in Europe. These included protocols and new trading conventions to enhance the standardization of CDS contracts in order to improve transparency, facilitate price comparisons across CDS contracts, and facilitate inventory management in case an unwinding of positions is necessary.

What wasn’t clear, however, was how a traditionally opaque market would react to these transparency measures. In the past, similar changes had been made in the bond market. Here, transaction costs had decreased while price competition between dealers increased. Nevertheless, bond dealers became more reluctant to hold large inventory of positions and began to move towards privately traded bonds and other alternative credit instruments like syndicated bank loans and CDS still exempt from public reporting and trade prices. In this case, post-trade transparency had lead to a significant reduction in trading activity, in particular for large issue size bonds.

It could be fairly assumed that more transparency in the CDS market would yield similar results: more competition, lower transaction costs, less price dispersion. That said, the average size of a CDS trade was much larger than a bond trade, approaching the $5 million mark. However, large investors fearing being front-run could also be more reluctant to trade in a more transparent environment. 

The impact of implementing transparency in opaque markets

Understanding how these changes in post-trade transparency might reshape the CDS market is of prime importance because of their hotly debated role since the financial crisis in the global financial markets system.

After the bailout of AIG and the Lehman collapse, the fear of systemic risk created by banks’ positions in CDS and fear that “the global economy could, possible, come to a halt” were real. The post-trade disclosure by DTTC first helped put a stop to unnecessary speculation on the size of the CDS market. Indeed, data showed that the real amount of CDS exposure was below that feared.

Our research, more specifically, investigates how dissemination by DTCC of post-trade data and the implementation of the Small Bang impacted CDS liquidity. The CDS market is very thin compared to equity markets - a very active corporate CDS may trade 20 times a day, while most trade only once per day. Therefore, to measure liquidity in this very liquid market, we developed a state-space model of bid and ask quotes that takes into account the low quoting activity of the CDS market and provides clean estimates of transaction costs and volatility. Using data from CreditMatch for the 175 most active European CDS, we run two event-studies: one around the DTCC release on October 31, 2007 and the other one around the Small Bang in July 2009.

Our results show that, following the post-trade transparency initiatives by DTCC, liquidity significantly improves only for CDS contracts whose reference entity is a bank or a major dealer of the CDS market. This result indicates that lifting the veil on the counterparty risk, especially related to the network of major dealers, removed some asymmetric information component and improved liquidity in these CDS contracts.  Regarding the implementation of the Small Bang, we find that liquidity is slightly but significantly better after the introduction of the new trading conventions and the new standardized definitions of CDS contracts. In particular, the Small Bang has benefited more illiquid contracts that have become more liquid. Overall, these results provide preliminary evidence in support of a greater transparency and standardization in the CDS market.

Our research offers new evidence that aggregated post-trade data publications by DTCC made liquidity better for reference entities related to banks and CDS major dealers, consistent with information revelations about contagion and counterparty risk in the CDS market. Second, it provides new insights into the impact of the Small Bang on liquidity, by showing that liquidity slightly improved across all CDS contracts. We thus show that the first transparency regimes initiatives had a small but significant positive impact in terms of liquidity, despite the expected small effects of these light regulatory changes. Therefore, we could expect that that the drastic regulatory changes implemented by EMIR in Europe or the Dodd-Frank Act in the US will have a stronger positive impact on liquidity for contracts eligible for real-time post-trade transparency. Our results will hopefully contribute to the current debate on transparency in the CDS market. 

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