Shorting Municipal Credit with CDS and Quanto Derivatives
Summary
The document explains why directly shorting municipal bonds can be difficult: short sellers generally need to borrow bonds, and tax-exempt interest economics can make lenders unwilling to lend them. A derivative referencing the bonds may not remove this friction, because a market maker hedging its exposure can face the same borrowing and financing problem. The response distinguishes taking a view on a bond issuer’s credit from taking a view on the currency in which the exposure is denominated.
Buying credit default swap protection is presented as a way to express a negative view on sovereign or municipal credit, subject to access to a counterparty and the required trading arrangements. A quanto-style CDS denominated in another currency can add exposure to how that currency responds to credit events. The answer also describes a proposed Bitcoin-linked, default-contingent structure, but says the contemplated trades never occurred. Practical limits include market access, regulatory constraints, counterparty willingness, and political resistance to credit-price discovery; the examples do not establish that such products are broadly available or liquid.
Key ideas
- Bond shorting usually requires borrowing the bond, which can be difficult for tax-exempt municipal debt.
- A derivative may leave the hedger facing the same bond-borrowing and interest-cost obstacles.
- CDS protection can express a negative view on an issuer’s credit, subject to market access and counterparty arrangements.
- A CDS denominated in another currency can combine credit exposure with a currency view.
- The described Bitcoin-linked default trade was proposed but never executed.
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Full text
# Derivatives to short municipal bonds based on cryptocurrency # Derivatives to short municipal bonds based on cryptocurrency Can you short municipal bonds with a cryptocurrency derivative? This is notoriously impractical in traditional finance, but there could be a crypto-based derivative designed around it. Is this a thing? ## Answer by Paul Brennan (score 1) https://quant.stackexchange.com/a/60053 Generally, to short a bond, you must borrow it, usually from a broker, and then sell it in the bond market. To make money you have to buy the bond back for less money and make money on that difference. The problem is that brokers won't lend out tax-free municipals, because the lender collects tax-free rates but pays the short seller taxable interest. If you are buying a derivative on these bonds, the market has to hedge out the exposure at some level. Market makers are still stuck with the tax-free to taxable interest issue when delta hedging their book. ## Answer by Dimitri Vulis (score 1) https://quant.stackexchange.com/a/60065 You can easily short a sovereign or municipal debt credit by buying CDS protection in the same currency in which their debt is denominated. For example, if you want to bet that the French EUR-denominated Obligations assimilables du Trésor (OATs) or USD-denominated general obligations of U.S. states of California or Illinois will be perceived by the markets as more crdit-risky, or even default, and if you can trade CDS (have an ISDA agreement with someone willing to sell you such CDS protection), buy at least 5 million notional of CDS protection, and you're all good. (But of course, European regulators don't want you to do this.) You'd only denominate a trade in currency (or cryptocurrency) other than the one they owe if you want to take a view on how this currency will react to a credit (or some other) event, i.e. a quanto CDS. For example, in the 1990s LTCM used to trade CDS on Italy sovereign denominated in ITL, USD, and XEU - in order to take a view on how these currencies would react not to a sovereign default (that did not seem likely) but to Italy's failure to join EUR (which did seem likely and would have moved Italy CDS spread a lot). Likewise, you could buy USD-denominated CDS protection on France sovereign to include a view on how USD/EUR rate would react to changes in France creedit. For example, a few years ago, before the most recent Venezuela sovereign default, I was working on CDS-like Bitcoin (XBT) trades contingent on Venezuela sovereign creidt. They were Bitcoin NDFs (making them derivatives:) - extinguishing and appearing, i.e. one party pays an upfront, and the other party owes / doesn't owe a Bitcoin (or an observed USD price of a Bitcoin) if Venezuela defaults / doesn't default. Clearly they include a view on what how Bitcoin price would react to Venezuela credit widening and eventually defaulting. Thes trades never happened, but a gold (XAU) linked to credit is pretty vanilla these days (i.e. one party promises to pay another the spot price of a troy oz of gold at maturity unless some reference entity defaults prior to that). I don't see how referencing cryptocurrency is any different from another currency or precious metal. A (surmountable) practical problem is that debtors don't like the idea of someone expressing a view on their creditworthiness in CDS and other markets. Government and municipal debtors, in particular, think they can bully market participants and suppress credit-price discovery. For example, EU tried to ban both short-selling bonds and buying CDS protection: https://ec.europa.eu/commission/presscorner/detail/en/MEMO_11_713 And here is an example of the Commune of California getting its panties in a knot over CDS: https://www.reuters.com/article/us-economy-california-cds/six-california-underwriters-pressed-again-on-cds-idUSTRE64467920100505 https://www.latimes.com/archives/la-xpm-2010-aug-19-la-fi-california-swaps-20100819-story.html https://www.bloomberg.com/news/articles/2010-09-28/california-treasurer-lockyer-calls-for-ban-on-muni-credit-default-swaps
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.