A Market for End-of-The-World Insurance? Credit Default Swaps on US Government Debt

Abstract

The market for credit default swaps (CDS) on US government debt is remarkably thin. Relative to the amount of reference debt, the market for CDS on USA is an order of magnitude smaller than the markets for CDS on other high-grade government borrowers, such as Germany and the UK. A common theory for the thinness of the US market is counterparty risk, but this explanation is difficult to reconcile with the privileged position that derivatives counterparties enjoy under US insolvency law. Moreover, the strong correlation between the insolvency risks of the US Treasury and of many financial firms means that sales of CDS on USA could be used opportunistically to transfer expected value from a protection seller’s general creditors to its shareholders. While there is no evidence that such correlation-seeking is yet occurring, regulators should not disregard the hazard, which if realized could distort CDS prices and exacerbate the systemic damage caused by a US debt restructuring.

Keywords: credit default swaps, sovereign debt, US Treasury debt, derivatives, bankruptcy, liquidation

JEL Classification: G33, G38, H63