Credit default swaps are financial instruments investors can use for hedging. In the case of government debt, investors use the swaps to express an opinion about the creditworthiness of a government, and to protect themselves in the event a country defaults or undertakes a debt restructuring.
The growing use of sovereign credit default swaps in advanced economy debt has raised questions about whether their speculative use could have destabilizing effects on the financial system, and how policymakers should respond. The European Union has recently banned the purchase of protection using these contracts if the buyer isn’t hedging, called naked selling of sovereign credit default swaps contracts.
In new research from the Global Financial Stability Report, the IMF said policymakers could improve the market for sovereign credit default swaps in other ways: by requiring more data disclosure, and by implementing the Group of Twenty regulatory reforms that aim to enhance the robustness and functioning of over-the-counter derivatives markets.
“Our study showed that sovereign credit default swaps are receiving a bad rap—they are no more or less effective at representing the credit risk of governments than are the government’s own bonds,” said Laura Kodres chief of the global stability analysis division in the IMF’s Monetary and Capital Markets Department and the head of the team that produced the analysis.
Not just for emerging economies anymore
Financial markets developed credit default swaps on government debt as flexible instruments to hedge and trade sovereign credit risks. Before to the global crisis, the market consisted largely of contracts on emerging market government debt because investors consider their credit risk as higher and more variable.
Although credit default swaps on government debt are only a fraction of countries’ outstanding debt market, their importance has been growing rapidly since 2008, especially in advanced economies where the creditworthiness of some of these countries have come under pressure. With the intensified attention, their usage has come under more scrutiny.
Debunking myths about credit default swaps
The IMF said credit default swap spreads provide indications of sovereign credit risk that reflect the...