WORKING PAPER

Credit Default Swaps,
Clearinghouses, and
Exchanges
Squam Lake Working Group on Financial Regulation
July 2009

1

Squam Lake Working Group on Financial Regulation

The Squam Lake Working Group on Financial Regulation is a nonpartisan, nonaffiliated group of fifteen academics who have come together to offer guidance on the reform of financial regulation.
The group first convened in fall 2008, amid the deepening capital markets crisis. Although informed by this crisis—its events and the ongoing policy responses—the group is intentionally focused on longer-term issues. It aspires to help guide reform of capital markets—their structure, function, and regulation. This guidance is based on the group’s collective academic, private sector, and public policy experience.
To achieve its goal, the Squam Lake Working Group is developing a set of principles and their implications that are aimed at different parts of the financial system: at individual firms, at financial firms collectively, and at the linkages that connect financial firms to the broader economy.
The members of the group are
Martin N. Baily
Brookings Institution

Frederic S. Mishkin
Columbia University

Andrew B. Bernard
Dartmouth College

Raghuram G. Rajan
University of Chicago

John Y. Campbell
Harvard University

David S. Scharfstein
Harvard University

John H. Cochrane
University of Chicago

Robert J. Shiller
Yale University

Douglas W. Diamond
University of Chicago

Hyun Song Shin
Princeton University

Darrell Duffie
Stanford University

Matthew J. Slaughter
Dartmouth College

Kenneth R. French
Dartmouth College

René M. Stulz
Ohio State University

Anil K Kashyap
University of Chicago

2

INTRODUCTION
As its name suggests, the payoff on a credit default swap (CDS) depends on the default of a specific borrower, such as a corporation, or of a specific security, such as a bond. The value of these instruments is especially sensitive to the state of the overall economy. If the economy moves toward a recession, for example, the likelihood of defaults increases and the expected payoff on credit default swaps can rise quickly. The Depository Trust and Clearing Corporation (DTCC) estimates that in
April 2009, the notional amount of credit default swaps outstanding was about $28 trillion. As a result of the overall size of the CDS market and the sensitivity of CDS payoffs to economic conditions, large exposures to credit default swaps can create substantial systemic risk.
Because of this potential for systemic risk, some have argued that credit default swaps should be cleared through central clearing counterparties, or clearinghouses. This paper analyzes the market for credit default swaps and makes specific recommendations about appropriate roles for clearinghouses and about how they should be organized. Clearinghouses are not a panacea and the benefits they offer will be reduced if there are too many of them. Further, clearinghouses that manage only credit default swaps but not other kinds of derivative contract may actually increase counterparty and systemic risk, contrary to the assumption of many policy makers.
THE MARKET FOR CREDIT DEFAULT SWAPS
A credit default swap can be viewed as an insurance contract that provides protection against a specific default. CDS contracts provide protection against the default of a corporation, sovereign nation, mortgage payers, and other borrowers. The buyer of protection makes periodic payments, analogous to insurance premiums, at the CDS rate specified in the contract. If the named borrower defaults, the seller of protection must pay the difference between the principal amount covered by the CDS and the market value of the debt. When Lehman Brothers defaulted, for example, its debt was worth about eight cents on the dollar, so sellers of protection had to pay about ninety-two cents for each notional dollar of debt they had