OFR Paper Examines Impact of Reforms on Liquidity in CDS Market

The paper contributes to three separate strands of literature: on the market structure of bilateral markets and the behavior of dealers; the potential impact of the financial crisis reforms on market liquidity; and the empirical literature on inventory management and pricing by dealers, specifically for the single-name CDS markets. The paper provides background on the CDS markets and highlights the reforms that may have potentially influenced the behavior of CDS market participants—the Basel 2.5 and Basel III accords, rules requiring standardized financial contracts be cleared through central counterparties, the Volcker rule, the rules on margin requirements for bilateral transactions, and other rules, including the single counterparty credit limit rule.

In over-the-counter (OTC) markets, dealers facilitate trading by becoming market makers. The costs dealers face, including the cost of holding inventory on balance sheet, and the ease, or difficulty, of reducing their positions, determine the degree of liquidity they provide. A stylized model has been used to examine the implications of these costs on dealer behavior and market liquidity. The model is used to guide an empirical study of the single name CDS market between 2010-2016. It is found that transaction prices between dealers and clients have progressively become more dependent on the inventories of individual dealers rather than on the aggregate inventory across all dealers. It has also been found that the volume between clients and dealers decreases across all clients, with larger declines for clients that are depository institutions. Meanwhile, the volume of inter-dealer trades decreases, dealer inventories decline, and dealers with large inventories are more likely to trade with clients. These results are consistent with the view that regulatory reforms implemented following the 2007-09 financial crisis increased the cost of holding inventory for dealers and the cost of inter-dealer trading. While the results indicate that increased costs in the CDS markets have impacted liquidity provision, it cannot be ruled out that this was the intent of the reforms. To determine the socially optimal level of trading activity, it would be necessary to quantify both the benefits and costs of the level of trading. This remains an open question, both theoretically and empirically, for future research.

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Keywords: Americas, US, Banking, Securities, Credit Default Swap, Liquidity, Market-Making Cost, Basel III, OTC Market, Regulatory Reform, OFR