Using novel position and trading data for single-name corporate credit default swaps (CDSs), we provide evidence that CDS markets emerge as “alternative trading venues” serving a standardization and liquidity role. CDS positions and trading volume are larger for firms with bonds fragmented into many separate issues and with heterogeneous contractual terms. Whereas hedging motives are associated with trading volume in the bond and CDS markets, speculative trading concentrates in the CDS. Cross-market arbitrage links the CDS and bond market via the basis trade, compressing the negative CDS-bond basis and reducing price impact in the bond market. Received September 24, 2014; accepted January 17, 2016 by Editor Andrew Karolyi.

We provide a model of nonredundant credit default swaps (CDSs), building on the observation that CDSs have lower trading costs than bonds. CDS introduction involves a trade-off: it crowds out existing demand for the bond, but improves the bond allocation by allowing long-term investors to become levered basis traders and absorb more of the bond supply. We characterize conditions under which CDS introduction raises bond prices. The model predicts a negative CDS-bond basis, as well as turnover and price impact patterns that are consistent with empirical evidence. We also show that a ban on naked CDSs can raise borrowing costs.