Pricing Implications of Centrality in an OTC Derivative Market: An Empirical Analysis Using Transaction-Level CDS Data

Using transaction-level records making up the universe of single-name credit default swap (CDS) contracts in Japan, we document whether and how the relative centrality of sellers to buyers, which proxies for their search ability and thus bargaining power, affects single-name CDS prices. Our main findings are as follows. First, our panel estimation, which comprehensively controls for the standard pricing factors considered in practice (e.g., entities’ risk, counterparty risk, the notional amount, and maturity), suggests that CDS prices are higher the higher the relative centrality of sellers to buyers. Second, such centrality premium becomes more apparent under unfavorable market conditions and further increases when buyers attempt to unwind their short positions. Given the non-negligible quantitative impacts of relative centrality on CDS prices, we find that CDS prices to a large extent are determined by the bargaining power originating from the ability to search for counterparties. Third, deeper trade relations between sellers and buyers result in a centrality discount when market conditions are unfavorable and a centrality premium when market conditions are favorable. This result suggests that there is a tradeoff between the cost of maintaining relationship in periods of favorable market conditions and the benefit of securing cheaper access to CDSs in periods of unfavorable market conditions.