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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’).