Abstract
The CDS Big Bang (the protocol changes for the CDS market in April 2009) increased the upfront funding requirements for trading CDS contracts, especially for those with credit spreads further away from 100 and 500 basis points. Exploiting this natural experiment, we document direct evidence that a higher funding requirement reduces market liquidity, increases the absolute value of the CDS-bond basis, and CDS spread volatility. Our evidence highlights an unintended consequence of the ongoing standardization of OTC markets — while its intention is to reduce systemic risk, standardization may jeopardize market liquidity precisely during periods of financial distress.
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