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Systemic risk management in financial networks with credit default swaps

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  • Matt V. Leduc
  • Sebastian Poledna
  • Stefan Thurner

Abstract

In this paper we study insolvency cascades in an interbank system, in which banks are permitted to insure their loans with credit default swaps (CDSs) sold by other banks. We show that, by properly shifting financial exposures from one institution to another, a CDS market can be designed to rewire the network of interbank exposures, in ways that make it more resilient to insolvency cascades. In devising a systemic insurance surcharge to be added to the CDS spread, a regulator will consider information about the topology of the interbank network. Thus, CDS contracts are effectively penalized according to how much they contribute to increasing systemic risk. CDS contracts that reduce systemic risk remain untaxed. We simulate this regulated CDS market using an agent-based model (CRISIS macro-financial model) and demonstrate that it leads to an interbank system that is more resilient to insolvency cascades.

Suggested Citation

  • Matt V. Leduc & Sebastian Poledna & Stefan Thurner, . "Systemic risk management in financial networks with credit default swaps," Journal of Network Theory in Finance, Journal of Network Theory in Finance.
    • Handle: RePEc:rsk:journ8:5343306
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    1. is not listed on IDEAS
    2. Tathagata Banerjee & Zachary Feinstein, 2018. "Impact of Contingent Payments on Systemic Risk in Financial Networks," Papers 1805.08544, arXiv.org, revised Dec 2018.
    3. P'al Andr'as Papp & Roger Wattenhofer, 2021. "Debt Swapping for Risk Mitigation in Financial Networks," Papers 2107.05359, arXiv.org.
    4. Aymeric Vié & Alfredo J. Morales, 2021. "How Connected is Too Connected? Impact of Network Topology on Systemic Risk and Collapse of Complex Economic Systems," Computational Economics, Springer;Society for Computational Economics, vol. 57(4), pages 1327-1351, April.
    5. P'al Andr'as Papp & Roger Wattenhofer, 2020. "Network-Aware Strategies in Financial Systems," Papers 2002.07566, arXiv.org.
    6. Poledna, Sebastian & Bochmann, Olaf & Thurner, Stefan, 2017. "Basel III capital surcharges for G-SIBs are far less effective in managing systemic risk in comparison to network-based, systemic risk-dependent financial transaction taxes," Journal of Economic Dynamics and Control, Elsevier, vol. 77(C), pages 230-246.
    7. P'al Andr'as Papp & Roger Wattenhofer, 2020. "Sequential Defaulting in Financial Networks," Papers 2011.10485, arXiv.org.
    8. Runjie Xu & Chuanmin Mi & Rafal Mierzwiak & Runyu Meng, 2019. "Complex Network Construction of Internet Financial risk," Papers 1904.06640, arXiv.org, revised Aug 2019.
    9. Kamil Fortuna & Janusz Szwabi'nski, 2023. "The Unified Framework for Modelling Credit Cycles with Marshall-Walras Price Formation Process And Systemic Risk Assessment," Papers 2305.06337, arXiv.org.
    10. Xu, Runjie & Mi, Chuanmin & Mierzwiak, Rafał & Meng, Runyu, 2020. "Complex network construction of Internet finance risk," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 540(C).
    11. Aymeric Vi'e & Alfredo J. Morales, 2019. "How connected is too connected? Impact of network topology on systemic risk and collapse of complex economic systems," Papers 1912.09814, arXiv.org.
    12. P'al Andr'as Papp & Roger Wattenhofer, 2020. "Default Ambiguity: Finding the Best Solution to the Clearing Problem," Papers 2002.07741, arXiv.org, revised Oct 2021.
    13. Runjie Xu & Chuanmin Mi & Nan Ye & Tom Marshall & Yadong Xiao & Hefan Shuai, 2020. "Risk Fluctuation Characteristics of Internet Finance: Combining Industry Characteristics with Ecological Value," Papers 2001.09798, arXiv.org.
    14. Chulwook Park, 2020. "Interconnected Conditions of Homogeneous and Heterogeneous Behavior in Agent-Based Models- Matrix with Calculated Vectors," Biomedical Journal of Scientific & Technical Research, Biomedical Research Network+, LLC, vol. 25(4), pages 19333-19341, February.
    15. Sebastian Poledna & Abraham Hinteregger & Stefan Thurner, 2018. "Identifying systemically important companies in the entire liability network of a small open economy," Papers 1801.10487, arXiv.org.
    16. 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.
    17. Wang, Hu & Li, Shouwei, 2020. "Risk contagion in multilayer network of financial markets," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 541(C).
    18. Diem, Christian & Pichler, Anton & Thurner, Stefan, 2020. "What is the minimal systemic risk in financial exposure networks?," Journal of Economic Dynamics and Control, Elsevier, vol. 116(C).
    19. Chulwook Park, 2019. "Network and Agent Dynamics with Evolving Protection against Systemic Risk," Papers 1907.11622, arXiv.org.

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