Credit default swaps and systemic risk


We present a network model for investigating the impact on systemic risk of central clearing of over the counter (OTC) credit default swaps (CDS). We model contingent cash flows resulting from CDS and other OTC derivatives by a multi-layered network with a core-periphery structure, which is flexible enough to reproduce the gross and net exposures as well as the heterogeneity of market shares of participating institutions. We analyze illiquidity cascades resulting from liquidity shocks and show that the contagion of illiquidity takes place along a sub-network constituted by links identified as ’critical receivables’. A key role is played by the long intermediation chains inherent to the structure of the OTC network, which may turn into chains of critical receivables. We calibrate our model to data representing net and gross OTC exposures of large dealer banks and use this model to investigate the impact of central clearing on network stability. We find that, when interest rate swaps are cleared, central clearing of credit default swaps through a well-capitalized CCP can reduce the probability and the magnitude of a systemic illiquidity spiral by reducing the length of the chains of critical receivables within the financial network. These benefits are reduced, however, if some large intermediaries are not included as clearing members.

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  1. 1.

    Although not in the restricted sense of requiring the core and periphery to be complete subnetworks, which is not realistic.

  2. 2.

    Defined by DTCC as ‘any user that is, or is an affiliate of a user who is, in the business of making markets or dealing in credit derivative products’ DTCC (2010).

  3. 3.

    Such a situation may arise from large jumps in mark-to-market values of net OTC derivatives payables, stemming for example from large correlated jumps in the spreads of reference entities of CDS. Institutions with large unilateral positions are particularly prone to this kind of illiquidity. Nonetheless, our model allows for a bank to become fundamentally illiquid via an exogenous shock like a run by short term creditors.

  4. 4.

    Rehypothecation refers to an institution posting as collateral to its creditors the collateral that it received from its debtors.

  5. 5.

    These may be sovereigns, corporates, banks, etc.

  6. 6.

    We thank one of the referees for pointing out this alternative construction.


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We thank three anonymous referees for helpful comments that improved the presentation of the paper. We thank seminar participants at the Mathematical Modeling of Systemic Risk Workshop (Paris, June 2011), the IMF Workshop on Systemic Risk Monitoring (2010), the Capital Markets Function Seminar (NY Fed, December 2011), the Research in Options Conference (Buzios 2011), Information and Econometrics of Networks Workshop (Washington DC, 2012) and the Symposium on Critical Challenges at the Interface of Mathematics and Engineering (2012) for helpful discussions.

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Correspondence to Andreea Minca.

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This paper is derived from Chapter 5 of Andreea Minca’s PhD thesis (Minca 2011).

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Cont, R., Minca, A. Credit default swaps and systemic risk. Ann Oper Res 247, 523–547 (2016).

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  • Systemic risk
  • Financial networks
  • Multi-layered network
  • Credit default swaps
  • Financial crisis
  • Intermediation chains
  • Financial stability