Credit default swaps and financial stability

Rama Cont ()
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Rama Cont: LPMA - Laboratoire de Probabilités et Modèles Aléatoires - UPMC - Université Pierre et Marie Curie - Paris 6 - UPD7 - Université Paris Diderot - Paris 7 - CNRS - Centre National de la Recherche Scientifique

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Abstract: Credit default swaps (CDSs), initially intended as instruments for hedging and managing credit risk, have been pinpointed during the recent crisis as being detrimental to fi nancial stability. We argue that the impact of credit default swap markets on fi nancial stability crucially depends on clearing mechanisms and capital and liquidity requirements for large protection sellers. In particular, the culprits are not so much speculative or "naked" credit default swaps but inadequate risk management and supervision of protection sellers. When protection sellers are inadequately capitalised, OTC (over-the-counter) CDS markets may act as channels for contagion and systemic risk. On the other hand, a CDS market where all major dealers participate in a central clearing facility with adequate reserves can actually contribute to mitigating systemic risk. In the latter case, a key element is the risk management of the central counterparties, for which we outline some recommendations.

Keywords: systemic risk; credit default swap; CDS; clearinghouse; central counterparty; CCP (search for similar items in EconPapers)
Date: 2010-07-01
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Citations: View citations in EconPapers (25)

Published in Financial Stability Review, 2010, 14, pp.35-43

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Persistent link: https://EconPapers.repec.org/RePEc:hal:journl:hal-00545742

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