The Determinants of Insider Trading in the Credit Default Swap Market-A Network Perspective

Abstract

Compared to the corporate bond and stock markets, investors prefer the CDS market to implement insider trading since the CDS market is less regulated and trading in this market on their private information is relatively easy without generating great transaction costs. Social networks, board networks in particular, are one of the central features of most economic activities and play an important role in information transmission. Therefore, investors are motivated to make use of the informational advantage gained from well-connected directors in the CDS market. In this paper, we investigate whether and how insider trading in the credit default swap (CDS) market is influenced by the corporate board network, formed by interlocking boards. We use CDS innovation as a proxy for the intensity of insider trading in the CDS market. To estimate the centrality of a firm position in the board network, we use the average quintile ranks of the four commonly used normalized board network centrality measures. We test our hypothesis based on a large sample of U.S. firms from 2004-2014 and find strong evidence that firms with a more centralized position in the board network experience a higher degree of insider trading in the CDS market. Our results suggest that the board network facilitates private information leakage to investors, resulting in more active informed trading in the CDS market. Moreover, such an association is more pronounced for firms with negative earnings news and for firms with weak corporate governance. In addition, using the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) as a quasi-natural experiment, we document that insider trading becomes less active after the passage of the Dodd-Frank Act. Our results still hold when we repeat the baseline analysis using four centrality measures separately or when controlling for the number of banking relationships. Our results add both to the insider trading literature and the social networks literature by examining the relationship between board network centrality and insider trading behavior in the CDS market. The findings indicate that board networks could serve as a relationship network that transmits private information to outside investors.