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

Abstract

We study financial networks and reveal a new kind of systemic risk arising from what we call default ambiguity—that is, 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 has shown that when banks can only enter into debt contracts with each other, 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. This paper was accepted by Gustavo Manso, finance.