Credit Default Swap Spreads: Funding Liquidity Matters!

This paper explores the relationship between funding liquidity and credit default swap (CDS) spreads, evidencing the effects of the regulatory changes brought about by the introduction of the CDS Small Bang reforms for CDS contracts on European reference entities in June 2009. Using panel estimations, this study provides evidence that a tightening of funding liquidity increases CDS spreads, an effect which is three times larger in magnitude for high-CDS entities compared to low-CDS firms. This relationship increases in magnitude and significance after the implementation of the CDS Small Bang reforms which introduced fixed coupons for trading CDSs, leading to the exchange of upfront fees between CDS contract parties.