How did CDS trades increase the interconnectedness of financial institutions?

Expert Solution

Credit Default Swap

CDS are derivative instruments. It helps the participants of financial market to transfer credit exposure. The buyer makes periodic payments to the seller in exchange for a positive pay off.

CDS trades have increased the interconnectedness of financial institutions because of its nature. The structure of CDS market throws light to the interconnectedness feature of CDS market. The dealers and non-dealer entities are inter connected. Geographical proximity ia a reason for such interconnection. Aggregate transaction activities are happening in CDS market connecting corporate financial and non financial entities. There is correlation between these CDS counterparties who are the financial institutions.

The impact of this interconnectedness is negative. Such a correlation always increase counterparty risk. Since these parties are correlated, risk from one financial institution may spread to another.

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