A Look at Credit Default Swaps and Market Makers

Are market makers contrarian? Evidence of the credit default swap market

Deming Wu

Government of the United States of America – Office of the Comptroller of the Currency (OCC)

May 19, 2015

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This article examines how a market maker adjusts its credit default swap (CDS) holdings in response to changes in CDS spreads over different time intervals and finds mixed evidence. Specifically, the negative correlation between weekly changes in CDS spreads and changes in net CDS positions suggests that market makers are “leaning against the wind” and absorbing short-term liquidity shocks. This correlation, however, turns positive during the monthly interval, implying that market makers follow trends. Finally, this correlation is insignificant over the quarterly interval, suggesting that market makers are not betting on the direction of the CDS spread over the long term.

Are market makers contrarian? Evidence of the Credit Default Swap Market – Introduction

Proprietary trading is the buying and selling of financial instruments with the intention of profiting from the difference between the buying price and the selling price. Following the financial crisis of 2007-2009, policymakers and regulators became increasingly concerned about the adverse effects of proprietary trading on financial stability. Therefore, the Volcker Rule, a provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act that was enacted in 2010, prohibits proprietary trading by commercial banks unless it whether it is legitimate market making activity or specifically aligned hedging. According to Duffie (2012), over-the-counter (OTC) markets essentially cover all transactions in bonds, loans, mortgages, currencies, commodities and around 60% of the notional stock of derivatives. In an over-the-counter market, brokers act as market makers by stating the prices at which they will buy and sell a security. Unlike conventional brokers who simply match buyers and sellers, a market maker acts as a counterparty when an investor wants to sell or buy securities. Conventional wisdom suggests that market makers would “lean against the wind” by absorbing liquidity shocks and offering “immediacy” to investors (Weill, 2007). In other words, market making is a form of proprietary trading designed to provide liquidity to investors. In light of this important role, critics of the Volcker Rule argue that it will reduce the ability of market makers to provide liquidity. This study examines how market makers trade credit default swaps using a new dataset that tracks each market maker’s CDS positions on individual companies over time.

A credit default swap (CDS) is a credit derivative contract that transfers the risk of default of one or more reference entities from the protection buyer to the protection seller. Under a CDS contract, the protection buyer is entitled to protection on a specified nominal value (i.e. the notional amount) if a credit event occurs for the reference entity (for example, default, bankruptcy or credit event specified in the contract). In return for this protection, the buyer of the protection pays a periodic fee (i.e. the CDS premium or spread) to the seller of the protection until the expiry date of the CDS contract. Since CDS are traded in the OTC market with low transparency, we know little about how market makers trade CDS (Stulz, 2010). Indeed, the lack of transparency hampered the ability of policymakers to craft effective responses during the 2007-2009 financial crisis (Bank for International Settlements, 2013; Financial Stability Board, 2009). Therefore, one of the aims of this study is to provide empirical evidence that facilitates an informed debate on the role of market makers in the CDS market.

More specifically, I examine how a market maker adjusts its CDS positions on a company in response to a change in the CDS spread of this reference entity. Because the primary goal of market makers is to facilitate trades rather than take directional positions, they are expected to buy or sell securities based on their clients’ demands, rather than betting on the price direction of the securities. . Therefore, if a market maker is effectively leaning against the wind by absorbing liquidity shocks and providing “immediacy” to investors, then the market maker will reduce its net CDS position on a reference entity when its customers will increase their demands for this CDS. In other words, one would expect a negative relationship between changes in a reference entity’s CDS spread and changes in a market maker’s net CDS position in that reference entity.

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