Credit Derivatives, Disintermediation and Investment Decisions

Abstract

The credit derivatives market provides a liquid but opaque forum for secondary market trading of banking assets. I show that when entrepreneurs rely upon the certification value of bank debt to obtain cheap bond market finance, the existence of a credit derivatives market may cause them to issue sub-investment grade bonds instead, and to engage in second-best behaviour. Credit derivatives can therefore cause disintermediation and thus reduce welfare. I argue that this effect can be most effectively countered by the introduction of reporting requirements for credit derivatives.

Keywords: Credit derivative, monitoring, junk bonds, debt finance, capital structure.

JEL Classification: G24, G28, G34