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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 find significant incremental information revelation in the credit default swap market under circumstances consistent with the use of non-public information by informed banks. The information revelation occurs only for negative credit news and for entities that subsequently experience adverse shocks, and increases with the number of a firm's relationship banks. We find no evidence, however, that the degree of asymmetric information adversely affects prices or liquidity in either the equity or credit markets.

[B]anks must not use private knowledge about corporate clients to trade instruments such as credit default swaps (CDS), says a report [by] the International Swaps and Derivatives Association and the Loan Market Association...[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) Credit derivatives have been perhaps the most significant and successful financial innovation of the last decade. The use of credit derivatives has been cited as an important reason for the observed robustness of banks and financial institutions to the historically high global levels of corporate defaults during the period 2000–2004. As Alan Greenspan recently observed, “The new instruments of risk dispersion have enabled the largest and most sophisticated banks in their credit-granting role to divest themselves of much credit risk by passing it to institutions with far less leverage. These increasingly complex financial instruments have contributed, especially over the recent stressful period, to the development of a far more flexible, efficient, and hence resilient financial system than existed just a quarter-century ago.”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 continues unabated as products are expanding to cater to emerging markets, and indices such as iBoxx and iTraxx are becoming industry benchmarks for credit conditions. If credit derivatives are to seamlessly provide insurance and liquidity-creation roles, then the orderly functioning of these markets becomes an important policy objective. 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 a creditor of Company X has private information about the likelihood of default, or can itself influence default, then this creditor might try to exploit its privileged information by buying credit insurance on X from a less-informed counterparty. Or if loan officers who deal directly with X pass on inside information to the traders buying credit derivatives, the institution on the other side of the trade could get a rotten deal. If fears of such behavior are widespread, the liquidity of the market could be threatened. Of course, asymmetric information and insider trading problems potentially exist in most markets. But the credit derivatives market may be especially vulnerable since, almost by definition, most of the major players are insiders. Firms have a much closer relationship with their private financiers, such as banks, than with investors in their public securities such as stocks and bonds. In particular, firms often provide material and price-sensitive information, such as revenue projection updates or acquisition and divestiture plans, to relationship banks well in advance of release to the public. Trading desks of many banks and financial institutions act as intermediaries in the credit derivatives market, quoting prices for protection written on corporations to which they have loan exposures. In the absence of perfect “Chinese walls” within banks, the credit derivatives market provides the trading desks of relationship banks a mechanism through which the information possessed by loan officers about a firm can be exploited and, in turn, transmitted in public markets. Indeed, some recent episodes in the credit derivatives markets reveal that this issue may have 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 in their white papers several cases of insider trading in companies 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.” Such events have also often been acknowledged in press (e.g., The Economist, “Pass the Parcel – Credit Derivatives,” January 18, 2003.) From an academic standpoint, the credit derivatives market is a particularly attractive laboratory for the testing of hypotheses pertaining to insider trading for several reasons: first, the potentially informed players, namely the banks, are well identified; second, the nature of private information (the likelihood of default) is unambiguous; third, incentives to exploit information (i.e., the magnitude of loan exposure and credit risk) are also measurable; and, finally, unlike much of the corporate bond market, daily data on prices of most widely traded credit derivatives are available since the start of the century. Given this motivation, we study the market for trading in credit default swaps (CDS), the most common credit derivative instrument, in order to measure the prevalence of informed trading and then to assess its effects on price and liquidity. We use data on the quoted CDS levels and bid-ask spreads for a cross-section of U.S. firms over the period January 2001 through October 2004. 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 informed revision of quotes or insider trading. We show that the information flow from the CDS market to the stock market is greater for subsamples where we expect a priori that insider trading would be a more significant issue: entities that experience credit deterioration during the sample period, and whose CDS levels are generally high. Absent these conditions, there is no such incremental information revelation in the CDS market. Having identified a measure of information flow from the CDS market to the stock market, we next link this directly to a proxy for the number of informed insiders: banking relationships of a firm, calculated using the Loan Pricing Corporation's data. We find that the degree of information flow increases with the number of banks that have ongoing lending (and hence monitoring) relationships with a given firm. This finding is robust to controls for non-informational trade, liquidity of stock and CDS markets, short-sale constraints, and the level of firm risk. Crucially, information revelation in the CDS market is asymmetric, consisting exclusively of bad news. This finding is consistent with the greater incentives of banks to exploit private information upon adverse credit news, that is, in times when they seek to hedge their underlying loan exposures. If insider trading does exist in these markets, then it is possible that market makers will be less willing to make prices in these derivatives in situations where they perceive the likelihood of private information to be high. In particular, in volatile conditions or when default risks rise, the risk of insider trading could rise, resulting in a loss of liquidity precisely when hedging needs are greatest. Furthermore, the one-sided nature of insider trading risk in this market (i.e., default risk) suggests that the price level at which insurance is purchased could also be affected. These effects could, however, be counteracted by alternate considerations. The threat of information asymmetry might also induce gains in liquidity provision, depending on the market structure. First, since informed banks are also market makers, they could play a liquidity-provision role to learn about order flow in the relatively opaque markets for credit derivatives, along the lines of the experimental evidence in Bloomfield and O’Hara, 1999 and Bloomfield and O’Hara, 2000. Second, an increase in the number of banking relationships could increase not only information-based trading but also uninformed trading from portfolio rebalancing and regulatory arbitrage activities of banks. Finally, an increase in the number of insiders could cause them to compete, revealing information into prices rapidly and without much loss of market liquidity (Holden and Subrahmanyam, 1992). These mechanisms could render the potential harm of insider trading insignificant. To investigate this issue, we study whether liquidity providers in the CDS markets charge greater bid-ask spreads when insider-trading risk is greater, and whether this insider-trading risk affects the level of prices in credit derivatives markets. Answering these questions is important to understanding whether insider-trading risk in the CDS markets is a significant concern for the liquidity and orderly functioning of these markets. We find no evidence that the degree of insider activity, proxied by the number of banking relationships, adversely affects prices or liquidity in either the equity or the credit markets (after controlling for their standard determinants). If anything, the reverse appears to be true: CDS markets for corporate entities that have a large number of banking relationships tend to have smaller bid-ask spreads, on average. Furthermore, even the direct measure of illiquidity, the percentage bid-ask spread, has no explanatory power for the level of CDS fees. While our results highlight the complexity of the process of liquidity determination, they may have important implications for regulators. The institutional response to complaints of insider trading in CDS markets has been to issue voluntary guidelines on information sharing inside banks (issued by agencies such as the Joint Market Practices Forum and the Financial Stability Forum in North America), and on how “material non-public information should be handled by credit portfolio managers in European Union member states”, issued by the International Swap Dealers’ Association (ISDA), the Bond Market Association, and the Loan Market Association. Our results suggest that while the complaints against insider trading in CDS markets probably have merit, it is unclear whether there should be any regulatory action to curb insider trading if the objective of such action is to prevent the loss of liquidity or to avoid adverse pricing in credit derivatives markets. In particular, although we find that the CDS markets appear to be transmitting non-public information into publicly traded securities such as stocks, we do not find any evidence that insider trading in CDS markets is directly harmful.

In this paper, we provide empirical evidence that there is an information flow from the credit default swap markets to equity markets and that this flow is permanent and more significant for entities with a greater number of bank relationships. The information flow is concentrated on days with negative credit news, and for entities that experience or are more likely to experience adverse credit events. These findings are consistent with the existence of hedging by banks with lending exposure and access to privileged information. However, we do not find evidence that the degree of insider trading risk adversely affects prices or liquidity provision in the credit markets. This could be because our proxies are too noisy, or because informed players simultaneously play offsetting roles in the process of price determination. Our work constitutes a first step towards understanding whether there is a case for the current regulatory response to concerns about the threat posed by insider trading in these markets.