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

Management Science 66(5), 2020

18 Pages Posted: 5 Oct 2017 Last revised: 16 Jan 2021

See all articles by Steffen Schuldenzucker

Steffen Schuldenzucker

Goethe University Frankfurt

Sven Seuken

University of Zurich - Department of Informatics

Stefano Battiston

University of Zurich - Department Finance; Ca Foscari University of Venice

Date Written: June 26, 2019

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 (June 26, 2019). Management Science 66(5), 2020, Available at SSRN: https://ssrn.com/abstract=3043708 or http://dx.doi.org/10.2139/ssrn.3043708

Steffen Schuldenzucker (Contact Author)

Goethe University Frankfurt ( email )

Robert-Mayer-Str. 11-15
Frankfurt am Main, 60325
Germany

HOME PAGE: http://algo.cs.uni-frankfurt.de/~sschuldenzucker/

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 Finance ( email )

Plattenstrasse 32
Zürich, 8032
Switzerland

Ca Foscari University of Venice ( email )

Cannaregio 873
Venice, 30121
Italy

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