Default Ambiguity: Credit Default Swaps Create New Systemic Risks in Financial Networks

40 Pages Posted: 5 Oct 2017 Last revised: 6 Dec 2018

See all articles by Steffen Schuldenzucker

Steffen Schuldenzucker

University of Zurich - Department of Informatics

Sven Seuken

University of Zurich - Department of Informatics

Stefano Battiston

University of Zurich - Department of Banking and Finance; Swiss Finance Institute

Date Written: December 5, 2018

Abstract

We study financial networks and reveal a new kind of systemic risk arising from what we call default ambiguity, i.e., a situation where it is impossible to decide which banks are in default. Specifically, we study the clearing problem: given a network of banks interconnected by financial contracts, determine which banks are in default and what percentage of their liabilities they can pay. Prior work by Eisenberg and Noe (2001) and Rogers and Veraart (2013) has shown that when banks can only enter into debt contracts with each other, then this problem always has a unique maximal solution. We first prove that when banks can also enter into credit default swaps (CDSs), the clearing problem may have no solution or multiple conflicting solutions, thus leading to default ambiguity. We then derive sufficient conditions on the network structure to eliminate these issues. Finally, we discuss policy implications for the CDS market.

Keywords: Financial Networks, Credit Default Swaps, Systemic Risk, Clearing Systems

JEL Classification: C62, G01, G12

Suggested Citation

Schuldenzucker, Steffen and Seuken, Sven and Battiston, Stefano, Default Ambiguity: Credit Default Swaps Create New Systemic Risks in Financial Networks (December 5, 2018). Available at SSRN: https://ssrn.com/abstract=3043708 or http://dx.doi.org/10.2139/ssrn.3043708

Steffen Schuldenzucker (Contact Author)

University of Zurich - Department of Informatics ( email )

Binzmühlestrasse 14
Zürich, CH-8050
Switzerland

HOME PAGE: http://www.ifi.uzh.ch/en/ce/people/schuldenzucker.html

Sven Seuken

University of Zurich - Department of Informatics ( email )

Binzmühlestrasse 14
Zürich, CH-8050
Switzerland

HOME PAGE: http://www.ifi.uzh.ch/en/ce/people/seuken.html

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

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