Credit Default Swap (CDS) and stock price movements over the past four years show that banks may be using inside knowledge about their corporate borrowers to trade CDS, according to preliminary findings of a study by finance professors Viral Acharya and Timothy Johnson at the London Business School. The authors quantitatively illustrated the flow of information from the CDS to the equity markets and found that there is significant flow in corporations that have a greater number of bank relationships.
"This is not the kind of study you will see coming from an investment bank and highlights the importance of Chinese walls," said Arturo Cifuentes, a CDO industry official. "How compelling their case is depends on if some regulator will get hold of the study and finds something."
The authors found that CDS spreads moved before stock prices when negative news about certain companies emerged. "This implies that someone in the CDS market knows the bad news first and it may be banks that have a lending relation with a company," said Michiko Whetten, a quantitative credit analyst in the U.S. fixed-income research group at Nomura Securities International. There have been instances when bad news about a company comes out and banks with large lending arms have bought protection at the right moment, the study showed.
Acharya and Johnson collected data on daily closing quotes for widely traded CDS from January 1, 2001 through October 20, 2004, a period which saw the defaults of companies such as WorldCom and Enron Corp. The study does not point out specific banks and Acharya said they are in the process of gathering intra-day data on actual CDS transactions.