How Does Risk Flow in the Credit Default Swap Market?

42 Pages Posted: 24 May 2017

See all articles by Marco D'Errico

Marco D'Errico

University of Zurich; European Systemic Risk Board

Stefano Battiston

University of Zurich - Department of Banking and Finance; Swiss Finance Institute; Ca Foscari University of Venice

Tuomas A. Peltonen

European Central Bank (ECB)

Martin Scheicher

European Central Bank (ECB)

Date Written: March 29, 2017

Abstract

We develop a framework to analyse the Credit Default Swaps (CDS) market as a network of risk transfers among counter-parties. From a theoretical perspective, we introduce the notion of flow-of-risk and provide sufficient conditions for a bow-tie network architecture to endogenously emerge as a result of intermediation.

This architecture shows three distinct sets of counter-parties:

i) Ultimate Risk Sellers (URS),

ii) Dealers (indirectly connected to each other),

iii) Ultimate Risk Buyers (URB).

We show that the probability of widespread distress due to counter-party risk is higher in a bow-tie architecture than in more fragmented network structures. Empirically, we analyse a unique global dataset of bilateral CDS exposures on major sovereign and financial reference entities in 2011-2014.

We find the presence of a bow-tie network architecture consistently across both reference entities and time, and that the flow-of-risk originates from a large number of URSs (e.g. hedge funds) and ends up in a few leading URBs, most of which are non-banks (in particular asset managers). Finally, the analysis of the CDS portfolio composition of the URBs shows a high level of concentration: in particular, the top URBs often show large exposures to potentially correlated reference entities.

Keywords: flow-of-risk, systemic risk, credit default swap, financial networks, network architecture

JEL Classification: G10, G15

Suggested Citation

D'Errico, Marco and Battiston, Stefano and Peltonen, Tuomas A. and Scheicher, Martin, How Does Risk Flow in the Credit Default Swap Market? (March 29, 2017). ECB Working Paper No. 2041, Available at SSRN: https://ssrn.com/abstract=2973115 or http://dx.doi.org/10.2139/ssrn.2973115

Marco D'Errico (Contact Author)

University of Zurich

Andreasstrasse 15
Zurich, 8050
Switzerland

European Systemic Risk Board ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Stefano Battiston

University of Zurich - Department of Banking and Finance ( email )

Andreasstrasse 15
Zürich, 8050
Switzerland

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Ca Foscari University of Venice ( email )

Cannaregio 873
Venice, 30121
Italy

Tuomas A. Peltonen

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Martin Scheicher

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany
+49 69 1344 (Phone)
+49 69 1344 7949 (Fax)

HOME PAGE: http://www.ecb.europa.eu

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