The Interconnectedness and Systemic Importance in the U.S. CDS Market

Abstract

This study assesses systemic risk in the US credit default swap (CDS) market. After the bankruptcy of Lehman Brothers, the market introduced risk mitigation tools, such as central clearing and portfolio compression in addition to existing netting and collateralization. Because CDSs typically have been traded as over-the-counter derivatives, just after the bankruptcy, few contracts were through central clearing, whereas in the first half of 2015, this share increased to 26%. First, we estimate the bilateral exposures matrix using aggregate fair value data on Call Reports by the Federal Deposit Insurance Corporation (FDIC) and theoretically analyze interconnectedness in the US CDS network using various network measures. The robustness of the estimated bilateral matrix is fully assured by sensitivity analysis using a core-periphery model and modified Jaccard index. Second, we theoretically analyze the contagious defaults introducing the Eisenberg and Noe framework. The network analysis shows that three to six dealers were central in the network in the past. The default analysis shows the theoretical occurrence of many stand-alone defaults and one contagious default via the CDS network during the global financial crisis. A stress test based on a hypothetical severe stress scenario predicts almost no future contagious defaults. To conclude, the risk contagion via the CDS network is unlikely.