The Structure and Dynamics of the UK Credit Default Swap Market
25 Pages Posted: 5 Dec 2013
Date Written: November 8, 2013
Over-the-counter derivatives (OTCDs) have been at the centre of regulators' and policymakers' attention owing to widespread concerns that these markets contributed to the build-up of systemic risk in the 2007/08 financial crisis. In 2009 the G20 initiated a reform programme that aims to increase transparency and reduce systemic risk in these markets. This paper analyses the structure and dynamics in one segment of the OTCD market, namely the UK single-name credit default swap (CDS) market. For our analysis, we use transaction reports warehoused in the trade repository operated by the Depository Trust & Clearing Corporation (DTCC). The data span the time between January 2007 and December 2011 which enables us to take a close look at market activity during the financial crisis.
The data show that the UK CDS market is relatively small (in terms of values traded) and that trading is infrequent. Furthermore, activity is highly concentrated around the main dealers who provide liquidity by intermediating between ultimate CDS buyers and sellers. Importantly, the data also show that dealers continued to provide liquidity throughout and during the peak of the financial crisis. Thus, concerns about counterparty risk, which are inherently present in all OTCDs, did not seem to have impaired market functioning in the UK CDS market. Corroborating this, counterparty risk did not affect CDS trade execution prices, in the sense that dealer credit risk did not correlate with the prices at which dealers were able to sell protection. Finally, the data also show that there are no substantial differences in the execution prices of the various types of counterparties: most market end-users trade at approximately the same prices at which dealers trade with one another. This is an interesting finding given the opacity of this OTCD market.
From a more general point of view, this paper demonstrates the usefulness of trade repository data to regulators. Such data allow regulators to understand better the dynamics of these hitherto opaque OTCD markets and also to estimate derivatives exposures arising between the various counterparties, which is essential for supervision and prudential policy. On-going work with trade repository data at the Bank of England aims to examine these interconnections in more detail.
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