CREDIT DEFAULT SWAPS. CONTRACT CHARACTERISTICS AND INTERRELATIONS WITH THE BOND MARKET 
Discussion Paper No. 1 (February 2011)
JEL Classifications: G12, G18

Luca Amadei
CONSOB, Markets Division
e-mail: l.amadei@consob.it

Simona Di Rocco
CONSOB, Markets Division
e-mail: s.dirocco@consob.it

Monica Gentile
CONSOB, Research Division
e-mail: m.gentile@consob.it

Renato Grasso
CONSOB, Research Division
e-mail: r.grasso@consob.it

Giovanni Siciliano
CONSOB, Research Division
e-mail: g.siciliano@consob.it

download paper Discussion Paper No. 1 (view/download PDF)

Abstract

Since the financial crisis and, even more, since the recent sovereign debt crisis, the role of credit default swap (CDS) has been subject to growing attention by policy makers and regulators, because of fears that transactions of a speculative nature on the CDS market may amplify tensions on the bond markets. The link between CDS and bond markets is complex and it is deeply affected by their different degree of liquidity and by market imperfections exacerbated by the financial crisis. The recent turmoil has impacted on the feasibility of arbitrage strategies between the two markets, increasing the gap between CDS prices and underlying bonds rates; CDS prices tend however to have a leading role in the price discovery process when the market for the underlying bonds is less liquid. Having regard to the European government bonds market, there is no clear evidence that speculation through CDS has affected the prices of the underlying bonds, nor that it is possible to manipulate the price of CDS in order to generate de-stabilising informative signals on the credit risk of sovereign issuers. Regulatory responses to such concerns based on constraints or restrictions on CDS transactions must be assessed with extreme caution, because they might not have the desired effects and might have an adverse impact on the orderly functioning of the government bond market. Post-trade transparency obligations may instead mitigate the potential destabilising effects of CDS speculative trading.

ISSN 2281-3160