An ISDA-commissioned review of the “empirical academic literature” concluded that single-name credit default swaps (“CDS”) have a “positive impact on the supply of credit to many reference entities underlying traded CDS, suggesting the ability of lenders to hedge their credit exposures can make them more willing to extend credit.”
The review examined over 260 published academic articles and working papers. It determined generally that single-name CDS spreads:
- contain valuable information about the probability and severity of adverse credit events that an underlying reference entity may experience during the life of a CDS;
- reflect a risk premium that protection sellers demand in compensation for exposure to reference-entity-specific and systematic risks (both credit-related and non-credit-related);
- are anticipatory and contain information regarding future announcements about the credit risk and financial condition of an underlying reference entity;
- are used by financial institutions to achieve their desired risk/return profiles and commercial objectives;
- have a beneficial effect on the supply of credit to borrowers that are reference entities underlying traded CDS;
- are the primary market for price discovery, as compared to corporate bonds, and often precede equity markets in processing new information about underlying reference entities; and
- when first introduced, have an adverse effect on the liquidity of related debt and equity markets.
Lofchie Comment: Market participants enter into swaps for a reason: swaps provide benefits. It would be preferable for regulators to devise a regulatory scheme that maximizes the benefits of swaps to the economy (including to issuers that are the subjects of those swaps) rather than one that minimizes the number of swap transactions.