CDS and Sovereign Bond Market Liquidity Batchimeg Sambalaibat∗

During the recent debt crisis in Europe, policy makers responded to the controversy surrounding CDS by implementing a series of policies that banned CDS trading. I use these bans as quasi-natural experiments to identify how derivative markets affect liquidity of the underlying cash market. I document that a temporary CDS ban increased bond market liquidity but a permanent ban instead decreased bond market liquidity. To explain these patterns, I build a dynamic search-theoretic model of over-the-counter bond and CDS markets that features an endogenous liquidity interaction between the two markets. My model shows that these opposing patterns are due to the fact that bond and CDS markets are substitute markets in the short run but are complementary markets in the long run. My results challenge existing theories of liquidity interaction among multiple markets and the common perception that the CDS market is a more liquid market than the bond market. Are financial derivatives just redundant securities or do they affect the un-derlying asset, and in what ways? The recent crises in the US and in Europe and the policy debate surrounding these events illustrated our limited un-derstanding of the recent financial innovations and derivatives such as credit derivatives and securitization. In this paper, I study both empirically and theoretically how derivatives affect price and liquidity of the underlying as-set in a particular context: sovereign bond and credit default swap (CDS) markets.1 The controversy surrounding CDS during the debt crisis in Eu-rope culminated in a series of policies that banned “naked ” purchases of CD