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The Impact of Central Clearing on Counterparty Risk, Liquidity, and Trading: Evidence from the Credit Default Swap Market

57 Pages Posted: 15 Nov 2012 Last revised: 13 Nov 2013

Yee Cheng Loon

Securities and Exchange Commission (SEC)

Zhaodong Zhong

Rutgers University

Date Written: August 20, 2013

Abstract

This paper examines the impact of central clearing on the credit default swaps (CDS) market using a sample of voluntarily cleared single-name contracts. Consistent with central clearing reducing counterparty risk, CDS spreads increase around the commencement of central clearing and are lower than settlement spreads published by the central clearinghouse. Furthermore, the relation between CDS spreads and dealer credit risk weakens after central clearing begins, suggesting a lowering of systemic risk. These findings are robust to controls for frictions in both CDS and bond markets. Finally, matched sample analysis reveals that the increased post-trade transparency following central clearing is associated with an improvement in liquidity and trading activity.

Keywords: Central Clearing, Counterparty Risk, Systemic Risk, Liquidity, Credit Default Swap

JEL Classification: G12, G13, G14, G18, G28

Suggested Citation

Loon, Yee Cheng and Zhong, Zhaodong, The Impact of Central Clearing on Counterparty Risk, Liquidity, and Trading: Evidence from the Credit Default Swap Market (August 20, 2013). Journal of Financial Economics (JFE), Forthcoming. Available at SSRN: https://ssrn.com/abstract=2176561 or http://dx.doi.org/10.2139/ssrn.2176561

Yee Cheng Loon

Securities and Exchange Commission (SEC) ( email )

100 F Street NE
Washington, DC 20549
United States

Zhaodong Zhong (Contact Author)

Rutgers University ( email )

Department of Finance, Rutgers Business School
100 Rockafeller Road
Piscataway, NJ 08854
United States

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