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Default Ambiguity: Credit Default Swaps Create New Systemic Risks in Financial Networks

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  • Steffen Schuldenzucker

    (Department of Informatics, University of Zurich, 8050 Zurich, Switzerland;)

  • Sven Seuken

    (Department of Informatics, University of Zurich, 8050 Zurich, Switzerland;)

  • Stefano Battiston

    (Department of Banking and Finance, University of Zurich, 8050 Zurich, Switzerland; Swiss Finance Institute, 8006 Zurich, Switzerland)

Abstract

We study financial networks and reveal a new kind of systemic risk arising from what we call default ambiguity —that is, a situation where it is impossible to decide which banks are in default. Specifically, we study the clearing problem : given a network of banks interconnected by financial contracts, determine which banks are in default and what percentage of their liabilities they can pay. Prior work has shown that when banks can only enter into debt contracts with each other, this problem always has a unique maximal solution. We first prove that when banks can also enter into credit default swaps (CDSs), the clearing problem may have no solution or multiple conflicting solutions, thus leading to default ambiguity. We then derive sufficient conditions on the network structure to eliminate these issues. Finally, we discuss policy implications for the CDS market.

Suggested Citation

  • Steffen Schuldenzucker & Sven Seuken & Stefano Battiston, 2020. "Default Ambiguity: Credit Default Swaps Create New Systemic Risks in Financial Networks," Management Science, INFORMS, vol. 66(5), pages 1981-1998, May.
    • Handle: RePEc:inm:ormnsc:v:66:y:2020:i:5:p:1981-1998
    DOI: 10.1287/mnsc.2019.3304
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    References listed on IDEAS

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    Cited by:

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    2. Csóka, Péter & Herings, P. Jean-Jacques, 2021. "Uniqueness of Clearing Payment Matrices in Financial Networks," Research Memorandum 014, Maastricht University, Graduate School of Business and Economics (GSBE).
    3. Péter Csóka & P. Jean-Jacques Herings, 2021. "An Axiomatization of the Proportional Rule in Financial Networks," Management Science, INFORMS, vol. 67(5), pages 2799-2812, May.
    4. Csoka, Peter & Herings, P.J.J., 2022. "Centralized Clearing Mechanisms in Financial Networks : A Programming Approach," Discussion Paper 2022-008, Tilburg University, Center for Economic Research.
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    7. Giansante, Simone & Manfredi, Sabato & Markose, Sheri, 2023. "Fair immunization and network topology of complex financial ecosystems," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 612(C).
    8. Yuan, Ying & Wang, Haiying & Jin, Xiu, 2022. "Pandemic-driven financial contagion and investor behavior: Evidence from the COVID-19," International Review of Financial Analysis, Elsevier, vol. 83(C).
    9. Panagiotis Kanellopoulos & Maria Kyropoulou & Hao Zhou, 2021. "Financial Network Games," Papers 2107.06623, arXiv.org.
    10. Anne G. Balter & Nikolaus Schweizer & Juan C. Vera, 2020. "Contingent Capital with Stock Price Triggers in Interbank Networks," Papers 2011.06474, arXiv.org.
    11. Bitetto, Alessandro & Cerchiello, Paola & Mertzanis, Charilaos, 2023. "Measuring financial soundness around the world: A machine learning approach," International Review of Financial Analysis, Elsevier, vol. 85(C).
    12. Irena Barjav{s}i'c & Stefano Battiston & Vinko Zlati'c, 2023. "Credit Valuation Adjustment in Financial Networks," Papers 2305.16434, arXiv.org.

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