US Government Debt Different - Finance Department - University of ...

86 A Market for End-of-the-World Insurance? Credit Default Swaps on US Government DebtConclusionThe market for CDS on US government debt is remarkably thin. Ifwe compare the net value of sovereign-debt CDS outstanding withreference debt levels, we see that the US market is an order of magnitudesmaller than the markets for other large government borrowers,including those that also have high credit ratings. The prevailing explanationfor the thinness of the US market is counterparty risk, butthis explanation is difficult to reconcile with the privileged positionthat derivatives counterparties enjoy under US insolvency law. Moreover,the strong correlation between the insolvency risk of the USTreasury and that of many banking firms means that sales of CDS onUSA could be used opportunistically to transfer expected value froma protection seller’s general creditors to its shareholders. While thereis no direct evidence of such conduct in the current market, regulatorsshould not disregard this hazard, which if realized could distortCDS prices and over-concentrate contingent liabilities, therebyproducing conditions similar to those in the market for mortgagebackedsecurities in the years leading up to the 2008 financial crisis.