CDS Market Transparency and Equity Market Quality

Abstract

Following the recent financial crisis, increasing the transparency of credit default swap (CDS) markets has been a popular goal among regulators. We examine how changes in the transparency of the CDS market can impact liquidity in the corresponding equity market. We first extend a model of insider trading to include a public signal of firm value, and show that increasing the precision of this signal can lead to higher price impacts. This finding has important real-world implications for equity market quality: a difference-in-differences approach shows that, following the increase in CDS market transparency after the DTCC began releasing CDS trading positions in 2008, stocks with CDS contracts faced greater price impact and higher illiquidity than stocks without CDS traded.

Keywords: Market Transparency, Credit Default Swaps, Market Quality, Information Spillovers, Market Regulation

JEL Classification: G10, G12, G14