Credit Risk Sharing and Credit Market Regulation

We develop a tractable general equilibrium model to analyze credit risk sharing via credit default swaps (CDS) and CDS market regulation under aggregate uncertainty. If available equity capital is below a threshold, any equilibrium of the basic economy with no CDS markets features firm default and underinvests in firms relative to the efficient allocation. For low aggregate risk levels, there is a unique equilibrium of the economy with unregulated CDS markets in which bondholders are fully insured. Investment is efficient, and the efficient allocation can be implemented via transfers alone. For intermediate aggregate risk, the unregulated CDS economy overinvests, and a margin or collateral requirement on CDS sellers that becomes more stringent as aggregate risk increases is necessary for efficiency. When aggregate risk is high, the CDS market breaks down. A collateral requirement restores equilibrium and efficiency, but it must be maximally stringent and accompanied by a capital requirement that restricts CDS supply.