CDS contracts can reduce risks in financial markets by providing valuable insurance. In a recent paper, Bank of England research Robert Czech shows that CDS also offer another, more subtle benefit: an increase in the liquidity of the underlying bonds.
Using regulatory data on CDS holdings and corporate bond transactions, Czech provides evidence for a liquidity spillover effect from CDS to bond markets. Bond trading volumes are larger for investors with CDS positions written on the debt issuer, in particular around rating downgrades. He uses a quasi-natural experiment to validate these findings, and provides causal evidence that CDS mark-to-market losses lead to fire sales in the bond market.
Czech instruments for the prevalence of mark-to-market losses with the fraction of non-centrally cleared CDS contracts of an individual counterparty. The monthly corporate bond sell volumes of investors exposed to large mark-to-market losses are three times higher than those of unexposed counterparties. Returns decrease by more than 100 bps for bonds sold by exposed investors, compared to same-issuer bonds sold by unexposed investors. Czech’s findings underline the risk of a liquidity spiral in the credit market.