Assessing Contagion Risks from the CDS Market

Abstract

The authors assess the risk of contagion stemming from credit default swap (CDS) exposures. Based on a unique dataset provided both by the Depository Trust and Clearing Corporation and the European Securities and Markets Authority, they analyse the main features of the CDS market for European reference entities. They find that activity in this market is concentrated on a group of bank-type global derivative dealers, which they refer to as “super-spreaders”, given their high level of interconnectedness. The authors then carry out contagion analyses which tend to show that domino effects in the network of direct CDS exposures are unlikely to generate big disasters. Nevertheless significant contagion effects can arise from direct exposures to underlying assets, such as government bonds, or also from margin calls and collateral requirements generated by portfolios losses in correlated assets. Overall, contagion effects therefore arise more from indirect Interconnectedness than from direct contractual links among market participants. The paper draws some tentative policy lessons for monitoring and mitigating contagion risks and raises some issues regarding on-going discussions on over-the-counter derivatives.