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

Richard SquireSo far, there is little evidence that such “correlation-seeking” activityis occurring in the market for CDS on USA. But regulators shouldbe aware of the hazard and monitor protection sellers accordingly,rather than proceeding under a mistaken assumption that a tightlink between the solvency of the US Treasury and the solvency ofprotection sellers means that demand for CDS on USA will alwaysbe negligible.71The Size and Function of Markets for CDS on Government DebtAt the end of 2011, the gross notional value of outstanding CDScontracts worldwide was $28.6 trillion. 1 Of this amount, only $3.0trillion, or 10.5%, referenced government debt. 2 If, however, we lookat the market in terms of reference entities (that is, the borrowerswhose debts are referenced in the contracts), sovereign debt becomesmore important: in weekly lists of the ten largest reference entitiesby notional amounts, sovereign borrowers consistently represent alarge majority. 3 Protection sellers, in turn, tend to be large financialinstitutions, with just over half of all government-debt CDS writtenby five firms: Deutsche Bank, Goldman Sachs, Barclays, Citigroupand Bank of America. 4Government-debt CDS serves several potential functions for protectionbuyers, including the following:• Regulatory capital compliance: Banks that operate under minimumcapital regulations may be required to hold more capitalif, instead of investing in assets deemed safe, they invest in sovereigndebt with a low credit rating. This regulatory penalty canbe avoided, however, if the bank “covers” the debt by purchasingCDS from a highly rated protection seller. 5 By definition, this1 Bank for International Settlements, Credit default swaps, by sector (2011), http://www.bis.org/statistics/otcder/dt25.pdf. The “gross notional” amount is the total facevalue of outstanding CDS contracts without accounting for offsetting positions.2 Id.3 Depository Trust & Clearing Corporation (DTCC), Trade Information WarehouseData (Section IV), http://www.dtcc.com/products/derivserv/data_table_iv.php (last visited Oct. 25. 2012).4 Creditflux, CDS League Tables (2011), http://www.creditflux.com/Data/.5 D. Andrew Austin & Rena S. Miller, Treasury Securities and the US SovereignCredit Default Swap Market, Congressional Research Service Report for Congress(Aug. 15, 2011), http://www.fas.org/sgp/crs/misc/R41932.pdf.