How Trade Matching Forms in the Credit Default Swap Market

Abstract

We investigate the pairing of dealers and customers in credit default swap (CDS) transactions. Specifically, we analyse how a participant in a CDS transaction determines its trading partner in a matching game framework. Using comprehensive transaction reports from the Depository Trust & Clearing Corporation (DTCC), we show that the size of organisations and the degree of participation in CDS transactions are important factors for trade matching in the UK CDS market. This finding lends credence to the notion that `too big to fail' may prevail. Next, we find that dealers with more intermediation are more likely to be selected as trading partners, leading to greater concentration in the CDS market. We also find that counterparty risk plays an important role in trade pairing, but its effect differs by the type of market participants. For example, unlike other institutions, hedge funds prefer trading with risky counterparties during some periods. This finding is significant for policymakers because such incentives can potentially lead to contagion risk.