A recent working paper from the Treasury’s Office of Financial Research found that the high concentration of credit default swap (CDS) buyers (about five cover half the market) adds to price volatility because idiosyncratic shocks to one of the ‘megasellers’ has such a big impact on spreads.

“Fluctuations of the five largest sellers in the market account for nearly one-ninth of the variation in weekly CDS spread movements. To put this in perspective, observable firm-level and macroeconomic factors explain only one-sixth of spread variation over the same time period,” writes Emil Siriwardane for the Treasury’s Office of Financial Research and NYU Stern School of Business in his working paper Concentrated Capital Losses and the Pricing of Corporate Capital Risk.

But while that sounds like a good reason to regulate large CDS sellers, the actual effect has been to simply push the risk to less regulated players.

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CDS seller concentration contributes to financial fragility

The qualitative results of Siriwardane’s paper aren’t surprising. When major CDS sellers’ capital decreases, they are less eager to take on more risk and demand a higher premium for CDS protection, increasing spreads. Second, when CDS sales are dominated by a few major players, volatility goes up because fluctuations in any one of their portfolios has an outsized impact on the overall market.

But Siriwardane was able to back this up first with analysis of 600 million CDS positions covering 5700 underlying entities.

“The DTCC supplies trade processing and registration services for all major dealers of CDS, so I am able to effectively observe the entire U.S. market from 2010 to 2014,” he writes.

He found that a one standard deviation capital loss among the five largest CDS sellers resulted in a 2.8% increase in weekly CDS spreads, which is significant when you consider that the standard deviation for weekly CDS spreads was just 6% for the typical firm. He was also able to show that a one standard deviation increase in seller concentration results in a 2% increase in price volatility.

Hedge funds have picked up where dealers left off

“The fact that the level of risk bearing capital in a market impacts risk premiums provides a potential rationale for outside capital injections (e.g. bailouts) when sellers are under-capitalized,” writes Siriwardane. “A deeper point is that the distribution of capital injections can also have a substantial impact on pricing.”

At this point we’re basically talking about too-big-to-fail CDS sellers, as Siriwardane himself acknowledges. During the financial crisis AIG was the world’s largest CDS seller, but regulations haven’t forced to AIG to hold more capital to account for its CDS business, it’s caused AIG to pull back, and hedge funds have taken up the slack.

“A likely explanation for this pattern is that new regulation has made it less profitable (or even possible) for dealers to ultimately bear credit risk via CDS. Still, it is important to consider whether moving this function to the largely unregulated sphere of hedge funds and asset managers is optimal from a financial stability perspective,” writes Siriwardane.