Credit Default Swaps on Municipal Bonds

The municipal bond market has traditionally been viewed as a relatively safe market, where credit risk wasn’t a primary concern. The spate of fiscal crises that state and local governments have experienced in recent years, however, has changed this narrative. With credit risk increasingly on the forefront of investors and bond issuers’ minds, credit default swaps (“CDSs”) loom large as a financial derivative that can directly mitigate or hedge municipal credit risk. A nascent market for municipal credit default swaps (muni CDSs) does exist. The market, however, is thinly traded, and, for a number of reasons, a robust muni CDS market has not yet developed.

This Note explores whether a more robust muni CDS market should be developed and considers the available options for doing so. While a number of policies could make the muni CDS market safer and more robust, policymakers must grapple with costs and benefits that come with more widespread use of
muni CDSs. Besides tracing the reasons for the historical lack of a robust muni CDS market, this Note makes a number of additional contributions. It provides an overview of the mechanics and state of the extant muni CDS market. Additionally, it argues that the current distressed conditions within the municipal bond market may be tempering some of the constraints that have historically limited the muni CDS market. It also suggests a number of proposals that would help make the muni CDS market more robust, while also discussing at length the costs and benefits of these proposals.