Credit Risk Sharing and Credit Market Regulation

I show how aggregate risk influences credit default swap (CDS) markets and CDS regulation in an analytically tractable general equilibrium framework. For low aggregate risk, the equilibrium with unregulated CDS markets is efficient with bondholders being fully insured. A general efficient allocation can be implemented via transfers alone. For intermediate aggregate risk, a margin requirement on CDS sellers is also necessary to implement the general efficient allocation. If aggregate risk is sufficiently high, unregulated CDS markets break down. A margin requirement on CDS sellers restores equilibrium and efficiency, but it must be maximally stringent and accompanied by constraints on CDS purchases by buyers.