Does counterparty risk in derivative markets matter for market efficiency and the underlying fundamental assets? Over the past decade, the structure of Credit Default Swap (CDS) market has evolved from traditional bilateral contracts to central clearing following the Dodd-Frank Act. This study investigates the effect of central clearing on the information quality of single-name CDS and corporate bond prices. By leveraging the phased introduction of central counterparty as shocks to market efficiency within a staggered difference-indifference framework and propensity-score matching, we provide causal evidence that the predictability of corporate bond returns through CDS spread innovations significantly improves when the CDS is included in central clearing. This finding supports the hypothesis that central clearing improves the efficiency of the CDS market by reducing counterparty risk and related costs, especially in comparison to the corporate bond market, which, as a result, should exhibit delayed price discovery. The study delves into the economic implications of cross-market price discovery facilitated by trading strategies. In particular, it demonstrates that corporate bonds associated with centrally cleared CDS underperform-by an annual alpha of 4.58%-when there's an increase in the CDS spread, compared to those with CDS spread decreases. This performance gap cannot be explained by risk compensation or other bond characteristics.

This paper proposes empirical methods to measure Credit Default Swap (CDS) return and explores its factor structure. We find that approximated CDS returns deviate significantly from actual returns based on the upfront fee, computed with protection sellers' cash flows. Past CDS returns and the skewness positively predict CDS returns, suggesting that CDS buyers have lottery preferences and CDS sellers are either overconfident or speculative in trading. Conventional pricing factors have weak explanatory power. Corporate bonds have spillover effects on future CDS returns in that a zero-cost portfolio sorted by statistical moments of past bond returns explains the CDS cross-section.