The Illusion of Stability in Credit Markets
The pervasive belief in market infallibility - that “they think they know, “…just ain’t so,” as Mark Twain observed – is a dangerous foundation for investment. A miscalculation, a fabricated figure, can trigger a cascade of losses. Betting on an incorrect assessment of value inevitably leads to financial pain, potentially forcing asset sales. Given the strong correlation between equity and credit markets, a downturn in credit is highly likely to drag equities down with it. In extreme cases, a firm peddling false data could default, or even instigate defaults among those who relied upon it.
The further a perception strays from reality, the more devastating the eventual reckoning.
When the illusion shatters, investors react by shedding assets and abandoning speculative ventures to curtail losses. This creates a ripple effect, impacting those who profited from the initial speculation – the poker players betting on investor gains, the businesses servicing those investors. The danger escalates as speculation wanes,cash flow diminishes,and a significant shift towards perceived ‘safe haven’ investments occurs.
If doubts persist – often fueled by a lack of transparency regarding the extent of exposure – sellers of credit default swaps (CDS) will widen spreads on new contracts and face increasing margin calls as creditworthiness deteriorates. Issuance will slow, impacting both secondary market liquidity and pricing.
The most severe outcome arises when a margin call overwhelms a seller’s capacity to pay.In the case of cleared CDS, which accounted for 76% (US$4.1 trillion) of the US$5.2 trillion notional traded in Q2 2025, according to ISDA data, a central counterparty absorbs the defaulted firm’s position. However, uncleared trades – representing the remaining 21% (US$1.1 trillion) – leave the CDS buyer exposed to the seller’s default losses.
Firms with exposure to a defaulting entity will incur losses, the magnitude of which depends on the degree to which client funds were segregated from the collapsed firm’s assets.
The potential for a systemic event is mitigated by two key factors: the level of surprise and the degree of market discipline. The greater the discrepancy between perceived and actual value, the more jarring the correction and the steeper the fall. A defaulting party’s adherence to sound practices offers greater protection to its counterparties and clients. Similarly, prudent investors, with diversified portfolios, are less vulnerable to any single event.
Though, as former Citi CEO Chuck Prince famously stated, “Provided that the music is playing, you’ve got to get up and dance.” The allure of substantial rewards will always tempt some to embrace heightened risk.
Navigating the Uncertainty
Despite regulatory efforts to enhance transparency and limit cascading defaults as the 2008 financial crisis,progress has been incremental.
Investors, driven by the pursuit of higher returns, inevitably gravitate towards markets with fewer safeguards and reduced transparency. These environments are often found in niche areas, such as private credit, which theoretically limits the impact on the broader market.
One significant advancement as 2008 is market liquidity. The ability to trade credit even as its quality declines has increased substantially.The rise of electronic trading has lowered costs, and the proliferation of high-quality data supports both automated and manual liquidity provision.
The reduced cost of managing liquidity risk allows dealers to better support clients during sell-offs. Enhanced access to portfolio trading minimizes the risk of being left holding illiquid debt while liquid positions are readily traded.
This improved market structure has been demonstrated in recent events, notably the Credit Suisse situation, which showed that markets can absorb a sell-off when discipline is maintained and the element of surprise is minimized.
©Markets Media Europe 2025
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