The Computational Complexity of Financial Networks with Credit Default Swaps

Steffen Schuldenzucker, Sven Seuken and Stefano Battiston

Papers from arXiv.org

Abstract: The 2008 financial crisis has been attributed to "excessive complexity" of the financial system due to financial innovation. We employ computational complexity theory to make this notion precise. Specifically, we consider the problem of clearing a financial network after a shock. Prior work has shown that when banks can only enter into simple debt contracts with each other, then this problem can be solved in polynomial time. In contrast, if they can also enter into credit default swaps (CDSs), i.e., financial derivative contracts that depend on the default of another bank, a solution may not even exist. In this work, we show that deciding if a solution exists is NP-complete if CDSs are allowed. This remains true if we relax the problem to $\varepsilon$-approximate solutions, for a constant $\varepsilon$. We further show that, under sufficient conditions where a solution is guaranteed to exist, the approximate search problem is PPAD-complete for constant $\varepsilon$. We then try to isolate the "origin" of the complexity. It turns out that already determining which banks default is hard. Further, we show that the complexity is not driven by the dependence of counterparties on each other, but rather hinges on the presence of so-called naked CDSs. If naked CDSs are not present, we receive a simple polynomial-time algorithm. Our results are of practical importance for regulators' stress tests and regulatory policy.

Date: 2017-10, Revised 2019-05
New Economics Papers: this item is included in nep-ban
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

Downloads: (external link)
http://arxiv.org/pdf/1710.01578 Latest version (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:arx:papers:1710.01578

Access Statistics for this paper

More papers in Papers from arXiv.org
Bibliographic data for series maintained by arXiv administrators ().