The impact of central clearing on counterparty risk, liquidity, and trading: Evidence from the credit default swap market

TY - JOUR

T1 - The impact of central clearing on counterparty risk, liquidity, and trading

T2 - Evidence from the credit default swap market

AU - Loon, Yee Cheng

AU - Zhong, Zhaodong Ken

N1 - Funding Information: We are grateful for comments from Viral Acharya, Amy Edwards, Yu Fan, Gerry Gay, Yalin Gündüz, Francis Longstaff, Thomas Nellen, and participants at the 2013 Financial Intermediation Research Society Conference and 2013 Midwest Finance Association Annual Meeting. Special thanks go to the referee, Marti Subrahmanyam, and the editor, Bill Schwert, for helpful comments and suggestions that significantly improved the paper. We also thank IntercontinentalExchange, Inc. for kind assistance with questions regarding operational aspects of ICE Clear Credit. All remaining errors are ours. Zhaodong (Ken) Zhong acknowledges financial support from the David Whitcomb Center for Research in Financial Services and the Research Resources Committee of Rutgers Business School.

PY - 2014/4

Y1 - 2014/4

N2 - This paper examines the impact of central clearing on the credit default swap (CDS) market using a sample of voluntarily cleared single-name contracts. Consistent with central clearing reducing counterparty risk, CDS spreads increase around the commencement of central clearing and are lower than settlement spreads published by the central clearinghouse. Furthermore, the relation between CDS spreads and dealer credit risk weakens after central clearing begins, suggesting a lowering of systemic risk. These findings are robust to controls for frictions in both CDS and bond markets. Finally, matched sample analysis reveals that the increased post-trade transparency following central clearing is associated with an improvement in liquidity and trading activity.

AB - This paper examines the impact of central clearing on the credit default swap (CDS) market using a sample of voluntarily cleared single-name contracts. Consistent with central clearing reducing counterparty risk, CDS spreads increase around the commencement of central clearing and are lower than settlement spreads published by the central clearinghouse. Furthermore, the relation between CDS spreads and dealer credit risk weakens after central clearing begins, suggesting a lowering of systemic risk. These findings are robust to controls for frictions in both CDS and bond markets. Finally, matched sample analysis reveals that the increased post-trade transparency following central clearing is associated with an improvement in liquidity and trading activity.

KW - Central clearing

KW - Counterparty risk

KW - Credit default swap

KW - Liquidity

KW - Systemic risk

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U2 - 10.1016/j.jfineco.2013.12.001

DO - 10.1016/j.jfineco.2013.12.001

M3 - Article

SN - 0304-405X

VL - 112

SP - 91

EP - 115

JO - Journal of Financial Economics

JF - Journal of Financial Economics

IS - 1

ER -