Effect of Central Clearing on Counterparty Risk, Liquidity and Other Determinants of Corporate Credit Default Swaps

Abstract

Over-the-counter (OTC) trades are connected with a large amount of uncertainty regarding liquidity and counterparty risk. This paper shows that the recent implementation of regulated central counterparty clearing houses (CCPs) in the Credit Default Swaps (CDS) market reduces the impact of counterparty risk and liquidity on single name corporate CDS spreads listed in the S&P500. The results show evidence for the efficient risk management of CCPs and that transparency is increased in the CDS market. CDS spreads are determined by firm-specific and global factors. The determinants of CDS spreads are dependent on whether they are traded OTC or centrally. Using a novel technique to measure equity price fluctuations from high-frequency data show that the firm-specific stock market determines CDS spreads much stronger when CDS are traded OTC than when they are centrally cleared. Equity log-returns have a significant negative impact on CDS spreads, whereas equity volatility is positively related. The significant negative effect of the market-wide stock market climate on CDS spreads is independent of the trading place. The term spread has a negative effect and the market wide volatility a positive deterministic potential on CDS spreads only when they are traded OTC, whereas there is no effect when CDS spreads are centrally cleared. Interestingly, OTC traded CDS spreads are much better explained than centrally cleared ones.