How Does Risk Flow in the Credit Default Swap Market?

We develop a framework to analyse the Credit Default Swaps (CDS) market as a network of risk transfers among counter-parties. From a theoretical perspective, we introduce the notion of flow-of-risk and provide sufficient conditions for a bow-tie network architecture to endogenously emerge as a result of intermediation. This architecture shows three distinct sets of counter-parties: i) Ultimate Risk Sellers (URS), ii) Dealers (indirectly connected to each other),iii) Ultimate Risk Buyers (URB). We show that the probability of widespread distress due to counter-party risk is higher in a bow-tie architecture than in more fragmented network structures. Empirically, we analyse a unique global dataset of bilateral CDS exposures on major sovereign and financial reference entities in 2011-2014. We find the presence of a bow-tie network architecture consistently across both reference entities and time, and that the flow-of-risk originates from a large number of URSs (e.g. hedge funds) and ends up in a few leading URBs, most of which are non-banks (in particular asset managers). Finally, the analysis of the CDS portfolio composition of the URBs shows a high level of concentration: in particular, the top URBs often show large exposures to potentially correlated reference entities