Credit default swaps: why market signals can mislead

Credit default swaps have become one of the most widely used indicators of credit risk in global financial markets. Yet new analysis involving London Business School’s Professor Richard Portes suggests the signals they send may not always reflect underlying economic reality.

In a recent report prepared for the European Systemic Risk Board, Professor Portes and co-authors examine how credit default swap (CDS) markets function in practice. Their findings show that despite their prominence in financial markets and policy discussions, CDS spreads are often formed in markets with surprisingly limited trading activity and high concentration among a small number of participants.

“CDS spreads are frequently treated as precise indicators of credit risk,” says Portes. “But when prices are formed in thin and concentrated markets, they can also reflect market structure and liquidity conditions rather than underlying credit fundamentals.”

Credit default swaps allow investors to buy or sell protection against the risk that a borrower may default. They are used both for hedging and for taking positions on the creditworthiness of governments, banks, or companies. Because CDS spreads can be interpreted as implied probabilities of default, they are closely watched by investors, policymakers, and the media.

The study draws on detailed transaction-level data made available under the EU’s post-crisis derivatives reporting rules. The analysis reveals that trading in many single-name CDS markets is sparse. Even some of the most actively traded sovereign CDS contracts in Europe see only a handful of trades each day, often involving the same counterparties.

This limited liquidity matters. When markets are thin and dominated by a small number of traders, price movements can be amplified during periods of stress. Wider CDS spreads can then feed back into financial markets by raising borrowing costs for governments and companies and influencing investor sentiment.

The report also highlights the global and fragmented nature of CDS markets. A large share of trading in CDS referencing European entities takes place outside the EU, particularly in the United Kingdom and the United States. This limits the ability of authorities to monitor risks comprehensively.

To address these challenges, the researchers outline a series of policy proposals aimed at improving market functioning and oversight. These include expanding post-trade transparency for single-name CDS contracts, strengthening the quality and standardisation of derivatives reporting data, and enhancing international regulatory cooperation.

Another recommendation is to develop real-time monitoring tools that would allow authorities to track CDS market developments more closely during periods of financial stress.

Perhaps most importantly, the report cautions against over-reliance on CDS spreads as definitive measures of credit risk. While they remain valuable market signals, their interpretation should take into account the structural limitations of the markets in which they are formed.

As Portes notes, “CDS markets provide useful information, but they should be understood in context. Better transparency and data will help ensure that policymakers and market participants can interpret these signals more reliably.”

The findings contribute to a growing debate about how financial market microstructure can amplify systemic risk even in the presence of stronger post-crisis regulation.

To read the full report in Vox EU / CEPR, Credit default swaps: Analysis and policies, click here