Do Market Makers Lean Against The Wind? Evidence From The Credit Default Swaps Market

Deming Wu

Government of the United States of America – Office of the Comptroller of the Currency (OCC)

May 19, 2015


This paper examines how a market maker adjusts its holdings of credit default swaps (CDS) in response to changes in CDS spreads over different time intervals and finds mixed evidence. Specifically, the negative correlation between weekly changes in CDS spreads and changes in net CDS positions suggests that market makers “lean against the wind” and absorb liquidity shocks in the short run. This correlation, however, become positive over the monthly interval, implying market makers follow the trends. Finally, this correlation is insignificant over the quarterly interval, suggesting market makers do not bet on the direction of the CDS spread over the long run.

Do Market Makers Lean Against The Wind? Evidence From The Credit Default Swaps Market – Introduction

Proprietary trading is the purchase and sale of financial instruments with the intent to profit from the difference between the purchase price and the sale price. Following the 2007–2009 financial crisis, policymakers and regulators grew increasingly concerned about the detrimental effects of proprietary trading on financial stability. Consequently, the Volcker Rule, a provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act that was enacted into law in 2010, prohibits proprietary trading by commercial banks, unless it is a legitimate market making activity or a specifically aligned hedge. According to Duffie (2012), the over-the-counter (OTC) markets cover essentially all trades in bonds, loans, mortgage related securities, currencies, commodities, and about 60% of the outstanding notional amount of derivatives. In an OTC market, dealers act as market makers by quoting prices at which they will buy and sell a security. Unlike conventional brokers who merely match buyers and sellers, a market maker serves as the counterparty when an investor wants to sell or buy securities. The conventional wisdom suggests that market makers would “lean against the wind” by absorbing liquidity shocks and providing “immediacy” to investors (Weill, 2007). In other words, market making is one form of proprietary trading that is designed to provide liquidity to investors. In light of this important role, critics of the Volcker Rule argue that it will reduce the liquidity provision capacity of market makers. This study examines how market makers trade credit default swaps using a novel data set that tracks the CDS positions of each market maker on individual firms over time.

A credit default swap (CDS) is a credit derivative contract that transfers the default risk of one or more reference entities from the protection buyer to the protection seller. Under a CDS contract, the protection buyer is entitled to protection on a specified face value (i.e., the notional amount) if a credit event occurs to the reference entity (e.g., default, bankruptcy, or a credit event specified in the contract). In return for this protection, the protection buyer pays a periodic fee (i.e., the premium or CDS spread) to the protection seller until the maturity date of the CDS contract. Because CDS are traded in the OTC market with low transparency, we know little about how market makers trade CDS (Stulz, 2010). Indeed, the lack of transparency hindered the ability of policy makers to develop effective responses during the 2007–2009 financial crisis (Bank for Internatinal Settlements, 2013; Financial Stability Board, 2009). Therefore, one objective of this study is to provide empirical evidence that facilitates an informed debate over the role of market makers in the CDS market.

Specifically, I examine how a market maker adjusts its CDS positions on a firm in reaction to a change in the CDS spread of that reference entity. Because the primary objective of market makers is to facilitate trades rather than taking directional positions, they are supposed to buy or sell securities according to the demands of their customers, rather than betting on the direction of the security prices. Therefore, if a market maker indeed leans against the wind by absorbing liquidity shocks and providing “immediacy” to investors, then the market maker will reduce its net CDS position on a reference entity when its customers increase their demands for that CDS. In other words, we would expect a negative relationship between changes in the CDS spread of a reference entity and changes in the net CDS position of a market maker on that reference entity.

Credit Default Swaps

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