Snowball Effect of a CDS Market

Abstract:     
Exponential growth of credit default swaps market and the resulting pile of CDS contracts of notional value of $62 trillion by the end of 2007 as well as the OTC nature of the contracts are widely believed to be one of the main causes of the current crisis and its depth, because large volumes of CDS contracts create huge counterparty risks. Facing this critique, recently the financial industry was forced to settle a large portion of the outstanding contracts (albeit not all), and centralized clearing houses for CDS transactions have been created. In the paper, we construct a stylized model of a CDS market with two types of agents, which shows that if the beliefs are asymmetric and a negligibly small fixed transaction cost is present, then, following fluctuations of beliefs, the agents will find it optimal to either buy or sell new CDS contracts but not to cancel outstanding ones. As a result, the volume of CDS contracts increases endogenously and fast once the contracts at time 0 have been issued, even if no additional speculative motives are presumed. As a solution for this snowball problem in the CDS market, we suggest to modify CDS contracts in the same way as the forward contracts were modified and futures were created.

Number of Pages in PDF File: 27

Keywords: credit default swaps, counterparty risk, asymmetric information

JEL Classification: D81, D84, G12, G13

working papers series