Central clearing and CDS market quality

• DOI: http://doi.org/10.1002/fut.21906
• Published date: 01 June 2018
• Author: Carlos Vieira,Paulo Pereira da Silva,Isabel Vieira
• Date: 01 June 2018

Received: 2 March 2017

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Accepted: 31 December 2017

DOI: 10.1002/fut.21906

RESEARCH ARTICLE

Central clearing and CDS market quality

Paulo Pereira da Silva

1,2

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Carlos Vieira

2

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Isabel Vieira

2

1

CMVM—Portuguese Securities

Commission, Lisboa, Portugal

2

CEFAGE—Universidade de Évora, Évora,

Portugal

Correspondence

Paulo Pereira da Silva, CMVM—

Portuguese Securities Commission, Rua

Laura Alves 4, 1050-138 Lisboa, Portugal.

Email: paulosilva@cmvm.pt

Funding information

FEDER/COMPETE, Grant number:

POCI-01-0145-FEDER-007659; Fundação

para a Ciência e a Tecnologia,

Grant number: UID/ECO/04007/2013

This paper contributes to the literature on the impact of central clearing on financial

market quality. Focusing on the CDS market, a difference-in-differences analysis is

performed to identify effects of voluntary central clearing of contracts on ICECC and

ICECE. Patterns of market quality proxies are compared before and after central

clearing initiation. We conclude that central clearing improves liquidity, price

informativeness and precision, and also the integration of the CDS and stock markets.

Results are inconclusive for the impact on CDS price volatility.

KEYWORDS

central clearing, credit default swaps, liquidity, price efficiency

JEL CLASSIFICATION

G01, G12, G14, G18, G28

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INTRODUCTION

In the aftermath of the 2008 financial crisis, over-the-counter (OTC) derivative markets in general, and the credit default swap

(CDS) market in particular, were pointed out as partially responsible for the failures of Bear Stearns and Lehman Brothers and

the near collapse of AIG, at the time a dominant CDS protection seller with large unhedged positions (Acharya, Engle, Figlewski,

Lynch, & Subrahmanyam, 2009). Indeed, by then, exacerbated counterparty and concentration risks and the complex network of

exposures between participants generated by these markets were considered a major threat for overall financial stability.

In order to limit the negative effects of derivatives' trading on financial stability, leaders of the G-20 at the 2009 Pittsburgh

Summit agreed to take measures to improve transparency and to limit financial sector risks.

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Their commitment later

materialized in regulations such as the Dodd-Frank Wall Street Reform and Consumer Protection Act, approved by the US

Congress in 2010, or the 2012 European Union Regulation on OTC Derivatives, Central Counterparties, and Trade Repositories.

These regulatory changes motivated several impact assessments, including that of Benos, Payne, and Vasios (2016), who

explore the effect of the Dodd-Frank Act on the OTC interest rate swap market, or Loon and Zhong (2016), who examine the

impact of the reform on transaction costs and liquidity of CDS indices.

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Our analysis makes a contribution to this research area by

examining the impact of one of the most relevant proposals in the regulation of OTC derivative markets in the aftermath of the

financial crisis: the obligation of central clearing for standardized OTC derivatives. Specifically, we assess the effects of central

clearing on the quality of the CDS market, particularly on price efficiency and informativeness.

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The meeting's final communication read: “all standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where

appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-

centrally cleared contracts should be subject to higher capital requirements.”

2

Collin-Dufresne, Junge, and Trolle (2017) assess reforms other than central clearing in the Dodd-Frank Act.

J Futures Markets. 2018;38:731–753. wileyonlinelibrary.com/journal/fut © 2018 Wiley Periodicals, Inc.

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A central counterparty (CCP) clearing house is a default management infrastructure with the primary goal of limiting

counterparty risk between participants. Supporters of CCP clearing emphasize its advantages in reducing the exposure of

clearing members, eliminating redundant positions amongst dealers, and introducing a new risk management approach

(e.g., position limits and margin requirements) that minimizes losses in the event of a counterparty default.

An important by-product of central clearing initiation is an improved information environment in this once very opaque

market. Central clearing enables the collection and centralization of high-frequency information on market activity, transaction

prices, and counterparty exposures for the CCP and market participants, thereby promoting transparency. Precise and up-to-date

pricing information is required for the accurate marking-to-market of participants' positions and the effectiveness of risk

management procedures (e.g., initial margins and variation margins). By collecting and processing such data and making it

available to market participants, CCPs enhance transparency, granting investors, regulators, and researchers access to a bulk of

new information.

If the introduction of a CCP reduces information risk (about counterparties) and enhances post-trade transparency, as

contended by Acharya et al. (2009) and Acharya and Bisin (2014), then it may also have implications for the quality of the

CDS market. There is already em pirical evidence of liquidity improvements follo wing the inception of central clearing. Slive

et al. (2012) reported a modes t increase in liquidity, and Loon and Zhong (2014) showed th at central clearing increased CDS

liquidity and spreads, but with the latter remaining lower than settlement spreads used by the CCP in mark-to-market

valuations.

However, there is still a gap in the literature concerning the implications of central clearing for price efficiency and

informativeness, two aspects that also deserve researchers' attention. Given the prevailing consensus that liquidity facilitates

price precision and informativeness (e.g., Holmstrom & Tirole, 1993), an improvement of the latter is expected after CCP

inception in light of the above mentioned result by Slive et al. (2012) and Loon and Zhong (2014).

Yet, not all useful information related to informativeness is captured by liquidity. On the one hand, there is an

alternative view claiming that liquidity fosters noise trading, thus eliciting mispricing in certain contexts. The model

developed by Calcagno and Heider (2008) predicts higher mispricing following (positive) liquidity shocks when the new

equilibrium prompts a greater increment of noise trading. As argued by De Long, Shleifer, Summers, and Waldmann

(1990), if the proportion of noise traders in the market exceeds a critical level, this effect causes noise trading to grow in

relation to informed trading, eventually dominating the market. Greene and Smart (1999) and Bloomfield, O'Hara, and

Saar (2009) document higher levels of uninformed trading and mispricing even in the presence of liquidity

improvements.

It is thus unclear whether, in the context of the CDS market, central clearing boosts price efficiency even if transaction costs

plunge. If post-trade transparency and liquidity promote the activity of noise traders and hedgers, the mispricing of CDS spreads

may also increase. On the other hand, price informativeness is more closely related to the allocation of financial and economic

resources than liquidity. There is extensive literature addressing the association between price informativeness and real

efficiency (e.g., Bond, Goldstein, & Prescott, 2010; Dow & Gorton, 1997; Edmans, Goldstein, & Jiang, 2015; Ozdenoren &

Yuan, 2008; Subrahmanyam & Titman, 1999) and previous research highlighted the impact of CDS trading on firms' decisions

and on the overall real economy (e.g., Bartram, Conrad, Lee, & Subrahmanyam, 2017; Saretto & Tookes, 2013; Ashcraft &

Santos, 2009; Subrahmanyam, Tang, & Wang, 2014). In effect, CDS spreads act as barometers of the reference entities' credit

risk, making the assessment of relevant regulatory changes, and more precisely their impact on price efficiency, interesting for

policy makers and regulators.

In this study, we assess the impact of central clearing initiation on some facets of CDS market quality, namely liquidity,

volatility, and price efficienc y, and on the integration of CDS and stock markets. The analysis is developed using a samp le of

contracts on US and European single-name corporations that (voluntarily) initiated central clearing between 2009 and 2012,

at two clearing houses: Intercontinental Exchange Clear Credit (ICECC) and Intercontinental Exchange Clear Europe

(ICECE).

In a preliminary analysis, we confirm previously identified determinants of single-name CDS contract central clearing, using

a sample containing reference names that did, and that did not, become centrally cleared during the period of analysis. Consistent

with previous literature, we find that the level of trading activity is a relevant driver of central clearing initiation, but that the latter

is negatively related to CDS mid-prices and bid-ask spreads.

Regime changes, such as the one produced by the initiation of central c learing of CDS contracts, are quite rare. As quasi-

natural events that enable the isolation of the effects of increased transparency and information risk about counterparties,

while controlling for firm-specific and market-wide factors, they offer an opportunity to appraise prevailing theories. Thus,

following the initial analy sis of central clearing determinants, an event stud y methodology evaluates whether central cleari ng

impacted market quality variables. To generate counterfactual evidence, the changes in the patterns of the market quality of

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