How Credit Default Swap Trading Impacts Employment

A Credit Default Swap (CDS) is a financial derivative that allows investors to hedge or speculate on the credit risk of a borrower, such as a corporation or government. In a CDS contract, the buyer of the swap makes periodic payments to the seller in exchange for protection against the risk of default by the borrower. If the borrower defaults, the seller compensates the buyer, typically by paying the difference between the bond’s face value and its market value.

Reference [1] examined the impact of CDS trading on the employment growth of a firm. Firms may expand labour investments due to easier access to capital when CDS-protected creditors are more willing to lend with fewer restrictions. However, firms might also reduce employment growth because defaults with CDS-protected creditors can be more costly, as these creditors are less motivated to renegotiate and care less about borrowers’ continuation values. Consequently, CDS trading may increase financial distress risk for firms, potentially leading to workforce reductions. The authors pointed out,

We examine the real impact of the inception of CDS trading on corporate decisions. We focus on managerial decisions on employment growth, which is one of the fundamental issues in corporate investments. We find that introducing CDS contracts on firms’ debt reduces employment growth by using a comprehensive dataset of CDS transactions for North American firms from 1997 to 2018. To control for the endogeneity of CDS trading, IV analyses and different matching approaches are used to reduce the observable differences between firms with CDS trading and those without such activities. We also conduct reverse causality tests and placebo tests to verify our results. The findings are consistent with our baseline results. Furthermore, CDS firms reduce employment growth when they are more financially constrained or their managers are more risk averse. Channel analysis reveals that the inception of CDS trading affects employment growth through the financial distress channel since firms tend to be conservative in labor investments when the cost of default increases after CDS trading. In addition, the onset of CDS trading improves firms’ labor investment efficiency by averting labor over-investments, suggesting that CDS trading has beneficial consequences.

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In short, CDS trading decreases a firm’s employment growth, but it also prevents labor over-investment. Thus, it has overall beneficial effects on the firm’s efficiency.

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References

[1] Shaojie Lai, Shiang Liu, Xiaoling Pu, Jianing Zhang, The real effect of CDS trading: Evidence from corporate employment, International Review of Finance. 2024, 1–30