BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS.

There have been many claims that credit derivatives like credit default swaps (CDS) have lowered the cost of debt financing to firms by creating new hedging opportunities and information for investors. However, these instruments also give banks an opaque means through which to sever links to their borrowers, reducing lender incentives to screen and monitor. In this paper, we evaluate the impact that the onset of CDS trading has on the spreads that underlying firms pay at issue in order to raise funding in the corporate bond and syndicated loan markets. Employing matched-sample methods, we fail to find evidence that the onset of CDS trading affects the cost of debt financing for the average borrower. However, we do uncover economically significant adverse effects on risky and informationally-opaque firms. It appears that the onset of CDS trading reduces the importance of the lead bank's retained share in resolving any asymmetric information problems that exist between the lead bank and the participants in a loan syndicate. On a positive note, we do find a small positive impact of CDS trading on spreads at issue for transparent and safe firms, where the lead bank's share is much less important. Moreover, we document that the benefit of CDS trading on spreads increases once the market becomes sufficiently liquid. In the end, this financial innovations has increased the completeness of markets, but at the same time has created new problems by reducing the effectiveness of lead banks' loan shares as a monitoring commitment device.

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