Insider trading in the credit derivatives market has become a significant concern for regulators and participants. This paper attempts to quantify the problem. Using news reflected in the stock market as a benchmark for public information, we report evidence of significant incremental information revelation in the CDS market, consistent with the occurrence of insider trading. We show that the degree of this activity increases with the number of banks having lending/monitoring relations with a given firm, and is robust to controls for non-informational trade. Furthermore, information revelation in the CDS market is asymmetric, consisting exclusively of bad news, consistent with hedging activity by banks with loan exposure and private information. We find no evidence, however, that the degree of insider activity adversely affects prices or liquidity in either the equity or credit markets. If anything, the reverse appears to be true.
‘‘[B]anks must not use private knowledge about corporate clients to trade instruments such as credit default swaps (CDS), says a report drawn up by five bodies including the International Swaps and Derivatives Association and the Loan Market Association... The warning highlights the challenges credit derivatives pose to banks and regulators trying to build a functioning market infrastructure... [M]any banks and institutions are trading CDS instruments in the same companies they finance - sometimes because they want to reduce the risks to their own balance sheets.” (Financial Times, April 25, 2005 - ‘Banks warned on insider trading threat posed by market for credit derivatives’).
Credit derivatives have been perhaps the most important and successful financial innovation of the last decade. The use of credit derivatives has been suggested as an important reason for the observed robustness of banks and financial institutions to the historically high levels of corporate defaults all over the globe during the period 2000 to 2004.1 In addition, markets for credit derivatives have helped banks create synthetic liquidity in their otherwise illiquid loan portfolios.2 Not surprisingly, the growth in the size of this market remains unabated as products are expanding to emerging markets, and indices such as iBoxx and iTraxx are becoming industry benchmarks for credit conditions.
If credit derivatives are to provide seamlessly the insurance and liquidity creation roles for banks, then the liquidity of credit derivatives itself becomes a desirable feature of mar-kets. Credit derivatives however, like all forms of insurance, are subject to moral hazard (see, Duffee and Zhou, 2001) and asymmetric information risks. In this paper, we are concerned with the latter of these risks. Specifically, if some creditor of Company X has private information about the likelihood of default, or can itself influence default, then this creditor may try to exploit its privileged information by buying credit insurance from a less well-informed counterparty. Or if loan officers, who deal directly with a bank’s borrowers, pass on inside information to the traders buying credit derivatives, the institution on the other side of the trade may get a rotten deal.
Indeed, some recent episodes in the credit derivatives markets reveal that this issue may be real with potentially important implications for the efficiency of credit-risk transfer across institutions. In striking recent episodes, managers of Pacific Investment Management Co. (PIMCO), the largest bond investor in the U.S., have cited several cases of insider trading in credits such as Household International Inc., AT&T Wireless, and Sprint Corp.: “Credit default markets are a mechanism with which friendly commercial bankers ... can profit by betraying and destroying their clients through the use of inside information,” and “... firms with large lending departments would always come in and buy protection at exactly the right moment.”3 The underlying hypothesis behind these complaints is that first, the price at which default protection is bought conveys potentially valuable inside information about likelihood of default, and second, these prices may get affected also by temporary buying pressures. This has raised the interesting possibility that the actual default of a corporation and thus the prices of its securities are themselves affected by activities in credit derivatives markets, in particular, by insider or strategic trading.
