Division of Economic and Risk Analysis 1 Interconnectedness in the CDS Market 1 Giulio Girardi, Craig Lewis, Mila Getmansky 2 April 2014 Concentrated risks in markets for credit default swaps (CDS) are widely considered to have significantly contributed to the recent financial crisis. In this paper we study the structure of the CDS market using explicit connections based on the total number of CDS transactions, notional value of CDS transactions, and network diagrams. The main objective is to provide statistics that characterize the CDS market, the degree of counterparty concentration, the size of different contracts as well as underlying contractual features, and a preliminary analysis of interconnectivity. Our new approach informs the discussion of the structure and resulting fragility or stability of the CDS market and studies potential contagion among its participants. I. Introduction The concentration of transactions and positions in credit default swaps (CDS) markets among a select group of large dealers is widely considered to have significantly contributed to the recent financial crisis. Due to the highly concentrated and interconnected nature of bilateral CDS contracting, the counterparty risk associated with potential defaults of large protection sellers is a potential source of systemic risk. Historically, the decentralized nature of over-the-counter (OTC) derivatives markets has made it difficult for regulators and market participants to obtain reliable information about prices and market exposures. The lack of transparency with respect to exposures held by market participants complicates the management of counterparty risk. Reportedly, this was one of the reasons why, prior to the recent crisis, certain market participants like American Insurance Group (AIG) were able to create large, yet unobservable, exposures (e.g. Markrose et al. (2012)). To the extent that counterparty failures of a large swap market participant can result in sequential counterparty defaults and shock transmission through the swap market, the ensuing contagion can become systemically important. The U.S. Congress signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA) into law on July 21 st 2010. The DFA envisioned a set of reforms that 1 This memorandum was reviewed by Christof Stahel and Jennifer Marietta-Westberg (DERA), and Peter Curley and Gregg Berman, Division of Trading and Markets (TM). The U.S. Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement of any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author’s colleagues upon the staff of the Commission. 2 We thank Troy Causey and Benjamin Huston for excellent research assistance.