CDS as Insurance: Leaky Lifeboats in Stormy Seas

Abstract

What market features of Credit Defaults Swaps (CDS) exacerbate counterparty risk? To answer this, we formulate a model which elucidates key differences between these and traditional insurance contracts. First, we allow for insurer insolvency with asymmetric information as to its probability. We find that stable insurers become less stable because they are forced to compete on price. When insurer type is known, increased competition among insurers can create instability for the same reason. Second, we allow the insured party to have heterogeneous motivations for purchasing CDS. For example, some may own the underlying asset and purchase CDS for risk management, while others buy these contracts purely for trading purposes. We show that traders will choose to contract with less stable insurers, resulting in higher counterparty risk in this market relative to that of traditional insurance; however, a regulatory policy that removes traders can, perversely, cause market counterparty risk to increase. Finally, we introduce a Central Counterparty (CCP) and show that requiring CDS contracts to be negotiated through CCPs can push stable insurers out of the market, mitigating the benefit of risk pooling.

Keywords: credit default swaps, insurance, counterparty risk, banking, regulation, central counterparties

JEL Classification: G21, G22, D82, G18