Credit Default Swaps: Weapons of Mass Disclosure

By Michael Maiello, Capital Ideas

Originally published on TABB Forum

The multitrillion-dollar market for credit default swaps came under withering criticism during the 2007-10 financial crisis, and Warren Buffett famously deemed them “financial weapons of mass destruction.” But the CDS market may be improving transparency in the stock and bond markets, and more CDSs may lead to healthier and more robust markets.

The multitrillion-dollar (notional) market for credit default swaps (CDSs) came under withering criticism during the 2007-10 financial crisis. Warren Buffett famously deemed them “financial weapons of mass destruction,” and others compared them to taking out fire insurance on a neighbor’s home.

But the CDS market may be improving transparency in the stock and bond markets. Research suggests that hyper-informed CDS traders force company managers to disclose some of the negative news that only banks are privy to. 

CDS contracts are financial agreements that protect their buyers from default risk in exchange for a stream of payments known as the “CDS spread.” The owner of the CDS contract is compensated for negative credit events such as a downgrade or default, according to the terms of the contract. If CDS buyers and sellers believe that a negative credit event is likely, the spread that a buyer must pay to purchase the contract grows larger. 

The financial institutions that issue CDSs are often lenders to the underlying companies and, as such, have significant insight into the results of operations, balance-sheet quality, and the covenants attached to any outstanding debt. The CDS market is lightly regulated, and trades are generally conducted “over the counter,” in private negotiations between dealers. The securities have not been subject to the same insider-trading laws that govern stock purchases so, as in the commodities-futures markets, what would be considered insider trading in equities has been generally acceptable in CDS markets. The 2010 Dodd-Frank Act did make the CDS market subject to some insider-trading rules, but implementing those rules poses some serious challenges.

Because of the information advantage enjoyed by CDS-market participants, CDS prices generally lead stock and bond prices, so if a CDS spread widens it can signal future bad news for outstanding bonds and equities.

This can put pressure on corporate managers, who have strong incentives to delay revealing bad news. A company in danger of breaching a debt covenant would not have to reveal that to either stockholders or bondholders unless the covenant were actually breached, and it may delay mentioning the situation before mandatory reporting deadlines.

But the presence of a liquid CDS market makes delaying tactics more difficult to employ, argue Chicago Booth’s Regina Wittenberg-Moerman, Singapore Management University’s Jae B. Kim, University of Minnesota’s Pervin Shroff, and University of Toronto’s Dushyantkumar Vyas. Buyers and sellers of a company’s CDS contract are more apt to know how likely the company is to default, and will price that risk accordingly. CDS prices are also available to participants in the stock and bond markets.

The researchers find that companies with liquid CDS contracts are more likely to give earnings forecasts and issue press releases, both forms of disclosure where management has great latitude. They are 14 percent more likely to give earnings forecasts and 1 percent more likely to issue bad-news press releases. While the latter increase may sound modest, given the scarcity of such releases, that represents 15.8 percent of the total of such releases in a typical year.

“Our findings suggest that informed trading by lenders in the CDS market results in a positive externality for capital markets by eliciting enhanced voluntary disclosures, thus contributing to a richer information environment,” conclude the researchers.

Further, they cite previous work that details how “higher disclosure quality leads to more liquid equity trading due to reduced information asymmetry.” It may well be that more CDSs will lead to healthier and more robust capital markets in the future.