Price Discovery and Liquidity in the Credit Default Swap Market

The inefficient pricing of the CDS (credit default swap) market has been considered as one of the main causes of the Global Financial Crisis. As price discovery is theoretically related to liquidity, this has been considered a source of mispricing in this over-the-counter market. However the CDS market is dominated by informed (professional) traders, who possess high amounts of information that compensate for illiquidity. In this paper we propose (a priori) that price discovery is not impacted by trading liquidity in the CDS market, contrary to standard notions of liquidity, and this is due to informed traders. Using CDS data from 2003-2017 for over 230 entities, we find that price discovery has low dependency on trading liquidity, and this relationship holds before, during and after the Global Financial Crisis. We conduct additional tests using CDS exchange traded funds and detect liquidity is related to price discovery, implying that uninformed (retail) traders cause dependency between price discovery and liquidity. Our conclusions suggest that liquidity was not a significant factor in the inefficient pricing of CDSs, as some had speculated upon, and implications for liquidity provision in markets with informed traders