Rangarajan K. Sundaram

We address the paradox that financial innovations aimed at risk-sharing appear to have made the world riskier. Financial innovations facilitate hedging idiosyncratic risks among agents; however, aggregate risks can be hedged only with liquid assets. When risk-sharing is primitive, agents self-hedge and hold more liquid assets; this buffers aggregate risks, resulting in few correlated failures compared to when there is greater risk sharing. We apply this insight to build a model of a clearinghouse to show that as risk-sharing improves, aggregate liquidity falls but correlated failures rise. Public liquidity injections, for example, in the form of a lender-of-last-resort can reduce this systemic risk ex post, but induce lower ex-ante levels of private liquidity, which can in turn aggravate welfare costs from such injections.

This article studies bidding behavior in the novel and complex auctions that, since 2005, have determined recovery rates in the multi-trillion dollar credit default swap (CDS) market. We find that bids are substantially influenced by inventory effects (bidders’ CDS positions entering the auction), market illiquidity, and “winners curse” considerations. The economically and statistically significant extent of “bid-shading” induced by these factors explains why auction prices deviate significantly (on average >16%) from pre- and post-auction market prices for the same instruments even while auction-generated information is significantly informative for post-auction market price formation.

Among the most important types of derivatives to appear in recent years are credit default swaps. The ability of CDS to separate credit risk exposure from ownership of the debt securities issued by a risky borrower is a major step in risk management. But the mechanics of the CDS market have been problematical, including the fact that there can easily be more protection purchased and sold through CDS than there are bonds subject to that risk in existence. Originally, in the case of a credit event the protection buyer would deliver bonds issued by the defaulting borrower to the protection seller, who was obligated to buy them at par value. This physical settlement process has recently been replaced by cash settlement, in which the payoff is based on bond prices established in an auction of the deliverable bonds. But as Sundaram explains, this is not a simple auction. In this article, he describes its complexities and comments on its potential problems.