Empty Creditors and Sovereign Debt: What Now?
Capital Markets Law Journal, Forthcoming
23 Pages Posted: 1 Mar 2014
Date Written: February 28, 2014
This Article outlines a possible cure to the “empty creditor” problem in sovereign debt markets: a market for sovereign creditor control. Scholars and policymakers have long lamented the troubling influence of credit derivatives on sovereign debt. Lenders that use instruments like credit default swaps (CDS) to hedge their risks are widely regarded as posing serious risks for sovereign debtors looking to restructure their debts. According to the “empty creditor” hypothesis, lenders that purchase CDS protection against the risk of a sovereign’s default have strong incentives to disrupt restructuring proceedings. Not only are they safe from the consequences of such a default, but they should actually wish to hasten such an event in order to trigger repayment under their CDS.
Current theory has largely overlooked the role of those who sell credit protection in CDS markets and who thus assume credit risk on a sovereign borrower. These protection sellers should have a real interest in securing more efficient outcomes in sovereign restructurings. This Article argues that the interests of lenders and protection sellers are not entirely adversarial, as theory assumes. Rather, both lenders and protection sellers should have incentives to cooperate in the interests of maintaining their reputation, lowering their costs of participating in CDS markets and reducing the regulatory fallout from sovereign default. In building on these more positive incentives, this Article proposes the creation of a market in sovereign creditor control that would allow lenders and protection sellers to “trade” their control rights in sovereign debt. By allowing protection sellers to formally acquire key control rights in sovereign debt, such a market would facilitate two outcomes: (i) it would allow those with real skin in the game to have greater influence on sovereign debt governance both before and during restructuring; and (ii) it would diminish the voice of empty creditors in sovereign debt to secure more efficient and longer-lasting solutions to sovereign distress.
Keywords: sovereign debt, credit default swaps, CDS, credit derivatives, restructuring, bonds, empty creditors, Greece, ISDA, ICMA, Master Agreement, credit event, financial stability, financial distress, illiquidity
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