Counterparty Risk and Counterparty Choice in the Credit Default Swap Market

Abstract

We investigate how market participants price and manage counterparty risk in the post-crisis period using confidential trade repository data on single-name credit default swap (CDS) transactions. We find that counterparty risk has a modest impact on the pricing of CDS contracts, but a large impact on the choice of counterparties. We show that market participants are significantly less likely to trade with counterparties whose credit risk is highly correlated with the credit risk of the reference entities and with counterparties whose credit quality is relatively low. Furthermore, we examine the impact of central clearing on CDS pricing. Contrary to the previous literature, but consistent with our main findings on pricing, we find no evidence that central clearing increases transaction spreads.

Managing Counterparty Risk in OTC Markets

“…Our findings are consistent with Du et al (2016), who develop a statistical multinomial logit model for the counterparty choice of buyers in the CDS market. They find that market participants are more likely to trade with safer counterparties and tend to avoid trading with counterparties whose default risk is highly correlated with that of the reference entity of the CDS contract.…”

Counterparty Credit Risk and the Effectiveness of Banking Regulation

“…The authors also study the effect of CCR on the choice of counterparties. Du et al (2015) conclude that counterparty credit risk is managed mostly by choosing the right counterparty. Their evidence shows that dealers search for counterparties with high credit worthiness and low correlation to the underlying of the CDS contract.…”

“…Our analysis on a much more recent, European data set, reveal a 64 times larger larger effect: an increase of 100 basis points in the seller's credit spread would already translate to 7.2 basis point decrease in the price of the CDS. Du et al (2015) analyse a granular CDS data set with US transactions and also find that counterparty risk has an effect on the pricing of CDS contracts: 100 basis points increase in the sellers credit worthiness results in a decrease of 0.6 basis points in the CDS price. The authors also study the effect of CCR on the choice of counterparties.…”

“…We also eliminate six transactions with negative spreads because they are difficult to explain from an economic perspective and spreads above 1000 basis points because these companies are obviously in distress (cf. Du et al (2015)). In addition, we also drop transactions with missing upfront payment, currency type and recovery rate fields because these parameters are indispensable for correctly pricing a CDS.…”

The Pitfalls of Central Clearing in the Presence of Systematic Risk

“…Empirical evidence on the impact of central clearing on derivative markets has been growing only recently, fueled by the increasing availability of granular data. Examples, among others, are Loon and Zhong (2014), Duffie, Scheicher, and Vuillemey (2015), Du, Gadgil, Gordy, and Vega (2016), and Bellia et al (2019) for single-name CDS, Menkveld, Pagnotta, and Zoican (2015) for equity, Mancini, Ranaldo, and Wrampelmeyer (2016) for interbank repo, and Cenedese, Ranaldo, and Vasios (2018) and Dalla Fontana et al (2019) for IRS markets. In particular, Bellia et al (2019) provide empirical evidence that dealers typically clear contracts with risky counterparties that result in small CCP margins being paid, i.e., contracts with large netting benefits.…”