A Bundesbank working paper provides evidence that Credit Default Swap (CDS) spreads change significantly in accordance with (i) the direction of order flows, (ii) the size of transactions, and (iii) the type of counterparty. Apparent causes are asymmetric information, inventory risk and market power. The implication is powerful. Since transactions do not require commensurate changes in fundamentals and since CDS spreads are themselves used for risk management, institutional order flows can easily establish escalatory dynamics.
The price impact of CDS trading
Yalin Gündüz, Julia Nasev, and Monika Trapp
Discussion Paper, Deutsche Bundesbank, No 20/2013
The below are excerpts from the paper. Cursive text and emphasis have been added.
The point of the paper
“Credit default swap (CDS) premia are widely used as a market-based indicator for credit risk in research and practice….However, new market microstructure research shows that derivatives prices may also deviate significantly from the fundamentally justified prices if real frictions (inventory risks or market power) or informational frictions (asymmetrical distribution of information) exist.”
“We show that frictions cause CDS premia to deviate considerably from their fundamental values… our dataset [from the Depository Trust & Clearing Corporation, DTCC] contains 432,560 observations where 595 market participants submit information on CDS transactions for 70 German reference entities. According to the DTCC definition, 22 submitters are classified as dealers, and the remaining 573 as buy-side traders.”
The impact asymmetric information
Market microstructure suggests that traders interpret a positive (negative) order flow as a sign of a higher (lower) fundamental value of the reference entity. [We find] a significant premium increase when CDS traders sell protection, and a significant premium decrease when CDS traders buy. …We find that a trader who sells (buys) protection increases (decreases) her CDS premium relative to the last trading price by 1.3 bp, or 18% of the average CDS premium change. Compared to the market-average CDS premium, this trader charges a mark-up of 0.3 bps.
The impact of inventory risk
“CDS traders also increase premia to receive compensation for the risks they accumulate through CDS transactions (inventory risk)…CDS quotes usually apply to a given transaction size range, and are not representative for transactions outside this size range. Hence, traders can react to the higher inventory risk they accumulate in larger transactions by adjusting their premia.”
“We use transaction size and the change in the average market-wide CDS premium since the previous transaction as measures of the inventory risk a trader incurs. We find a considerable impact of inventory risk: transactions with higher inventory risk increase the premium by 7.9 bps on average, which equals 113% of the average premium change. The mark-up increases by factor five.”
The impact of market power
“Last, CDS traders use their market power to charge significantly higher premia in transactions with buy-side investors.”
“We analyze the impact of market power…by distinguishing between dealer and buy-side investor trades… Search costs can lead to market power of traders with lower search costs. Hence, a CDS buy-side trader could be more likely to trade at less attractive prices because of higher search costs. Consistent with this intuition, we find that asymmetric information and inventory risk only matter for trades with buy-side investors. There, a trader who has sold (bought) protection increases (decreases) their CDS premium by 3.5 bps (as compared to 1 bp for the full sample). If we consider inventory risk, the increase of the CDS premium is 7.8 bps higher than for dealers.”